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Generational Dynamics Web Log for 28-Mar-07
As foreclosures surge, people ask why mortgage lenders were so lax

Web Log - March, 2007

As foreclosures surge, people ask why mortgage lenders were so lax

Or, perhaps they did it on purpose, to be "predatory"

An article on the Calculated Risk blog tries to explain why mortgage borrowers committed fraud and why lenders were so lax about enforcing rules:

"The problem ... is that, recently, we seem to have an epidemic of predator meeting predator and forming an alliance: a borrower willing to commit fraud for housing meets up with a seller or lender willing to commit fraud for profit, and the thing gets jacked up to a whole new level of nastiness. ...

As soon as borrowers became convinced that paying substantially more for the property than the current seller did just a few months ago is always and everywhere a good sign, you could no longer rely on the "rational agent" borrower to at least limit his fraudulent tendencies to lying on the loan application in order to get away from apartment life. You actually see them agreeing to sign "secret" sales contract clauses that will require them to borrow more than the fair market value of the property, and then give the excess loan proceeds to someone who wonít be helping to repay the debt. Or accepting "down payment assistance" from an interested party, in order to buy a property whose price is inflated by the amount of the "assistance." That this doesnít seem to strike them as self-defeating tells you a lot about how uninformed or misinformed we are, how far into a true mania weíve gotten. In the old days, you used to be able to count on RE frauds to display basic self-interest, naked or camouflaged.

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didnít do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, thereís a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but itís small comfort when the losses rack up. ...

A recent CNN piece quotes a Clayton analyst as having found a mortgage note signed by "M. Mouse".... How did anyone miss that? ...

What I want to do instead is to make some general observations about why so much fraud is missed by lenders. Obviously, there are lenders who are colluding with borrowers, or who are defrauding investors or borrowers or some other party; thatís either "fraud for housing" or "fraud for profit" or the new hybrid of the two. To me, thatís the least interesting problem (although itís an important one). I want to talk about the extraordinarily widespread "insufficient caution" problem in this industry: the lenders who are just too easy to defraud. It seems to me that this problem gets to the heart of a lot of the issues we keep talking about here: toxic mortgage products, loose standards, out of control home price bubbles, and the endless chain of "disintermediation," outsourcing, temping, dumbing down, fragmenting, and otherwise morphing of the business of home mortgage lending into a big fraud magnet. It often seems as if the industry just stopped believing that it could ever really be at risk.

On the one hand, everyone does know that you canít run a mortgage lending business with the same level of anti-fraud measures they use at Dominoís to keep from wasting pizzas on prank calls. On the other hand, we are starting to seeóand I predict we will start to see a cascade ofóstories of lenders with such lax internal controls that if they did remember the risks, you have to conclude they just tried to repress those memories."

What I'd like you to get out of reading the above description is not the details about how fraud occurred; what I want you to do is get a "feeling" of what's been happening.

Remember that Generational Dynamics is not concerned about the behaviors and attitudes of an individual or small group of people; it's concerned with the behaviors and attitudes of large masses of people, entire generations of people.

So you should read the above description not for the details of the individual actors -- the buyers, the builders, the lenders, etc. -- and their actions, but the attitude that they all share -- the attitude that nothing really matters. There's little or no difference between victims and victimizers, between predators and prey.

Really, everyone has the same attitude, the sense that you'll make money and do all right no matter what.

And this is the generational attitude that comes about at the height of the bubble mania, just before a crash, as I discussed in my article based on research by Harvard economist Robert J. Barro.

Now, let's look back in history at the funniest bubble of the all, the Tulipomania bubble.

Pundits and journalists today look back on the Tulipomania bubble and laugh. Ha, ha! How could anyone be so utterly stupid to pay such inflated prices for a simple tulip? Or even worse, for a "tulip future," that gave you the right to own a particular tulip that would be grown in the following Spring? How could anyone be so dumb as to think that a tulip could ever be worth as much as a small house? Ha, ha! People were sure incredibly dumb in the 1630s, weren't they? Ha, ha! They must all have been on some sort of drugs or alcohol to do something so incredibly stupid. And when the tulip market crashed on February 3, 1637 -- well, how could they be such idiots not to have seen that coming? Ha, ha!

Well, let's take a look at what happened with this tulip mania. Here's an excerpt from the description given in Edward Chancellor's 1999 book, Devil Take the Hindmost, a history of financial speculation:

"The beginning of the tulpenwoerde, or what the Victorians called the tulipomania, is associated with the arrival in the tulip market around 1634 of outsiders who were apparently attracted by stories of rising prices for tulip bulbs in Paris and northern France. Among these entrants to the market -- later dismissed by Dutch florists as the "new amateurs" -- were weavers, spinners, cobblers, bakers, grocers, and peasants. Although the tulip craze grew to embrace most social classes, two parties were absent who might otherwise have brought stability to the trade. The wealthy amateur bulb collectors, who had long shown a readiness to pay vast sums for the rarer varieties, withdrew their custom as prices began to soar, while the great Amsterdam merchants continued investing their trading profits in town houses, East India stock, or bills of exchange -- for them, tulips remained merely an expression of wealth, not a means to that end.

The nature of the tulip market changed as the traffic increased. Private negotiations between individuals gave way to informal meetings in the rooms of inns, called Colleges, where trades and speculators could trade in convivial surroundings. ...

There were two methods of dealing: direct negotiation between two persons or general auction. The former method, called "with the plates," ... involved both buyer and seller inscribing an agreed price for a bulb on wooden plates provided by the College. Auctions were referred to as "in the naught" since the seller set a starting price by writing a figure in the middle of a slate circled with a zero. A commission of up to three guilders for "wine money" was paid by the buyer to the College, which was spent on tobacco, alcohol, light, and heating. Pleasure was mixed with profit....

No actual delivery of tulips took place during the height of the boom in late 1636 and early 1637 as the bulbs remained snug in the ground. A market in tulip futures appeared, known as the windhandel (the wind trade): sellers promised to deliver a bulb of a certain type and weight the following spring, buyers took the right to delivery -- in the meantime, cash settlement could be made for any difference in market price. Most transactions were expedited with personal credit notes which also fell due in the spring when the bulbs would be dug up and delivered. Gaergoedt boasts of having made 60,000 guilders from his tulip speculations but admits that he has only received "other people's writing." By the later stages of the mania, the fusion of the windhandel with paper credit created a perfect symmetry of insubstantiality: most transactions were for tulip bulbs that could never be delivered because they didn't exist and were paid for with credit notes that could never be honoured because the money wasn't there." (pp. 16-18)

Now, I want you to read this second description in the same way that you read the first one -- not for the details, but for the "feeling" for the attitudes of the people involved.

The point is, we're no different today than in the Tulipomania days. We've been doing exactly the same thing. We have the same kind of credit debauchery, the same kind of craziness, the same kind of "state of denial." Only the details are different; the attitudes and behaviors are identical.

We also a have a "perfect symmetry of insubstantiality" today: Americans' credit card debt keeps growing, even though it can't grow forever; America's international debt keeps growing, even though it can't grow forever; China lends more and more to the U.S., though it can't keep lending more forever; and China's 20-year-old bubble economy depends on selling textile and electronic goods to Americans, who purchase them with the money that China lends to America.

"On 3 February 1637, the tulip market suddenly crashed. There was no clear reason for the panic except that spring was approaching when delivery fell due and the game would be up. In Haarlem, the centre of the flower trade, rumours circulated that there were no more buyers, and the next day tulips were unsaleable at any price. Contracts were not settled, and one default followed another. The professional florists attempted in vain to extract payment from defaulting speculators."

Once the crash occurred, the "feeling" of credit debauchery ended, of course. In fact, the entire Western world learned its lesson from the Tulipomania crash. But, as the decades passed, the people who learned those lessons grew old and died, and the younger generations eventually developed the same behaviors and attitudes.

The epicenter of the Tulipomania crash was in Holland in 1637. The epicenter of the South Sea Bubble crash was in England, in 1721. The epicenter of the French Monarchy (bubble) bankruptcy was in France, in 1789. The epicenter of the Hamburg Crisis of 1857 (Panic of 1857) was in Germany. And the epicenter of the Wall Street crash of 1929 was, of course, in America.

Why does the epicenter keep changing? Well, I like to say that young generations forget the wisdom that they're parents tried to teach them, but it's just possible that the epicenter of a crash retains a tiny bit more of that wisdom than the others.

A few years ago, when I first began saying that we were headed for a new 1930s style Great Depression, people used to tell me, "It can't happen. In the 1930s, the Roosevelt administration put in new agencies and regulations to prevent another depression from ever occurring."

But of course the agencies and regulations that were created in the 1930s to prevent another depression have already failed.

Take the Securities and Exchange Commission. When I was high school in the 50s, my teachers all told me how the SEC was going to prevent a future depression. The 1930s depression was caused by the huge stock market bubble of the 1920s, where millions of investors drove up the prices of stocks by borrowing money from each other, a situation that led to a huge stock market correction in the 1930s. The SEC would prevent that from ever happening again by regulating margin rates, which would reduce buying stocks on credit, and prevent another huge stock market bubble. My 1950s high school teachers knew that because they lived through the 1930s, and understood that piece of wisdom.

Well, today all the people who remember that wisdom from personal experience are gone. And the SEC failed to prevent the huge 1990s stock market bubble. The SEC has completely failed to perform the principal function that it was originally set up for.

Still, those agencies and regulations still exist, and even though they've failed to do their jobs, they've at least slowed things down. We do have some sense of things going wrong, even though we're still in a state of mania.

But that's not true in China. I don't get the feeling from anything I've read that the Chinese have any idea at all what's going on. They seem to have no real concept of a bubble, and no real fear of a crash.

So I think that the epicenter of the next crash will be in China. The entire world will be economically devastated, of course, but my expectation is that the devastation will be greatest in China.

Recall that on February 26, I posted an article describing that the Shanghai stock market bubble appeared close to bursting. I described how people were selling their houses, borrowing money from friends and relatives, to do day-trading in the stock market. There seemed to be no sanity at all in the mania.

Well, it was very next day that a brief panic caused the Shanghai stock market to fall 8.8%, causing a small panic on Wall Street as well.

What caused the panic in Shanghai, and why did it spread around the world -- to Europe and then to America? No one knows.

Let me repeat a quote from Chancellor's book: "On 3 February 1637, the tulip market suddenly crashed. There was no clear reason for the panic except that spring was approaching when delivery fell due and the game would be up."

Well, maybe the Shanghai stock market mini-panic occurred on February 27 because spring is coming, and people suddenly feared that the game would be up.

Incidentally, guess what? The Shanghai stock market has completely recovered from the February 27 collapse, and is once again at NEW HIGHS. It was the seventh straight session when the market ended up.

So if it was a bubble on February 26, then isn't it an even bigger bubble on March 28?

As I've said so many times, it's not possible to predict when a panic will occur, but from the point of view of Generational Dynamics, we're now overdue for a generational panic and crisis. It could happen next week, next month or next year, but it's coming with certainty. It will destabilize densely packed populations in China and around the world, and will lead to the Clash of Civilizations world war. As usual, Generational Dynamics tells us our final destination, but not how we'll get there. (28-Mar-07) Permanent Link
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