The art of economics consists of looking not merely at the immediate but at the longer effects of any act or policy. It consists in tracing the consequences of that policy not merely for one group but for all groups.
This is the key lesson found in Henry Hazlitt’s masterpiece Economics in One Lesson. This book is required reading for anyone who fancies themselves an educated person. I learned far more about economics from this one short book than I ever did from my university economics courses.
What Hazlitt’s talking about here is the importance of understanding second order effects. That is to say, we need to consider the indirect consequences of a policy or decision to truly get a feel for its effectiveness.
This sounds perfectly logical. I doubt anyone would argue against its merit.
The problem is, second order effects typically aren’t immediately visible to us. Thus, people tend to focus only on the short term, direct results of a given policy or action – what they can see. Then they tend to ignore the indirect consequences that occur down the road. Out of sight, out of mind.
That being the case, I’ll share with you how I came to understand the importance of second order effects… and why they are often ignored.
My first career was in corporate banking. I got my start in the loss mitigation division of a major U.S. bank. And we were tasked with cleaning up the mortgage crisis in the wake of the 2008 fiasco.
For context, it’s estimated that around ten million homes in the U.S. went into foreclosure as a result of the financial crisis. The movie The Big Short does a pretty good job of telling that story.
But here’s the thing – the U.S. government decided that it was bad optics to allow so many foreclosures to happen. So the various government departments and government-sponsored entities involved in the mortgage market (HUD/FHA, VA, USDA, Fannie Mae/Freddie Mac) each developed loan modification guidelines for their mortgage products. Then they asked the banks to make them a priority.
The idea was that the banks could modify the loans for those who qualified per the new guidelines. Doing so would bring the mortgage current and stop foreclosure proceedings.
And the government entities even incentivized the banks to do as many modifications as possible. They agreed to pay the banks a flat fee for every modification completed.
Of course this sounded great to everybody. Let’s stop the foreclosures and let people stay in their homes. That’s how they sold the initiative.
Now, I worked in the HUD/FHA loss mitigation division within the bank. HUD refers to the Department of Housing and Urban Development. FHA stands for the Federal Housing Administration.
These two departments were instrumental in enabling people to buy a home with very little money down.
Per underwriting guidelines, homebuyers must put 20% on real estate purchases. But those who qualify for HUD/FHA loans can buy homes with just 3.5% down. That’s because the FHA backstops these loans by providing mortgage insurance to the lenders. The insurance protects the lender in case the borrower defaults.
So the bank instructed my group to comb through our entire portfolio of HUD/FHA loans and modify as many of them as we could. The modification process was as follows…
First, we took the past-due balance, including late payment fees and attorney fees, and we recapitalized it back into the mortgage. That means we added these fees to the mortgage’s principal balance. We basically stuck them at the end of the loan. This brought the loan current.
Next we dropped the interest rate to whatever the FHA’s floor rate was for the day. And then we re-amortized the mortgage back out to thirty years. That’s regardless of how many years the borrower had left on their loan.
Often this process would reduce the borrower’s monthly payment. They always saw that as a great deal. They went from nearly losing their home to having their house payment reduced. What’s not to like?
But here’s the thing I started to notice…
Sometimes these modifications would increase the mortgage balance materially. That’s because we were writing all the outstanding fees into the loan itself.
After I saw that happen a few times something important occurred to me. We weren’t comparing the new mortgage balance to the home’s market value before proceeding with these modifications. That wasn’t part of the process.
And if we remember, housing prices collapsed in light of the crisis. On the national level, U.S. homes fell by about 30% on average. But the decline was much worse in certain cities.
So many of our modifications likely made the homeowners severely underwater on their mortgage. They were walking out of the deal owing more on their home than it was worth.
I couldn’t help but wonder – were we setting people up to fail?
What if something happened and they needed to sell their house quickly in the coming years? They wouldn’t be able to. They were now stuck with an overvalued mortgage.
I brought this up at one of our morning meetings. I asked if we were assessing valuations at any point in the process. And I asked if we were going to track these modified mortgages to see how they perform in the years ahead. I figured that was the only way to know if these efforts were in fact successful.
Management didn’t like these questions. Those were things for the “higher ups” to worry about, they told me. My job was to get the modifications done.
That’s when I learned the hard way that nobody cared about the second order effects. They didn’t care if our modification initiative was successful long term.
For the government, they just wanted the foreclosure numbers to come way down. Then they could talk about how they saved the day.
And for the banks, they wanted to collect as much revenue from the government incentives as possible. I’m sure they were thinking about the massive bonuses they’d be able to pay themselves that year.
This single lesson likely changed the course of my professional life. Once I saw that nobody cared about the second order effects of what they were doing, I realized that I didn’t want to work in corporate banking much longer.
It also opened my eyes to just how negligent the government and major financial institutions are when it comes to economics. I suppose that’s why we’re in the position we’re in today…
-Joe Withrow
P.S. Don’t forget that we’ll be opening the doors of our investment membership The Phoenician League very soon. This will be just the third time we’ve accepted new members since we launched last year.
If you’re interested to learn more about what we’re doing, you can do so right here: The Phoenician League Waiting List