Libertarian University of Chicago Economist Luigi Zingales highlights two academic papers which provide evidence for the long-obvious belief that the Obama Administration pulled its punches when given the opportunity to indict bank executives for fraud in the creation and popping of the housing bubble. He, of course, doesn’t think that they show that, and does the natural libertarian thing of blaming “irresponsible” homeowners. But I think his explanation of the first paper is pretty clear (the second paper was in a draft form, so we don’t get to see the evidence).

It does so by exploiting a natural experiment generated by Illinois legislators. In 2006 they introduced mandatory counseling in selected Chicago neighborhoods, to repeal it only 20 weeks after it was introduced. Predatory lending is commonly defined as lending that imposes unfair and abusive loan terms on borrowers. The immediate effect of this mandatory counseling was to discourage almost half of the loans. While many good loans might have been prevented, it is safe to say that probably almost all the predatory ones must have been curtailed. What was the effect on later defaults? The authors find that defaults were reduced by one third. Thus, predatory lending was clearly not the only factor, not even the biggest one in the housing crisis. Yet, it might have been an important contributing factor.

A reduction in defaults by 1/3 simply by giving mandatory counseling to borrowers seems like a tremendous consequence to me. And there’s a huge assumption made here that non-predatory loans simply didn’t exist after mandatory counseling. The difference between the counseling stage and the non-counseling stage was that borrowers were getting mixed messages instead of one loud message coming from the side of the banks. I’m fairly certain that banks are as persuasive, if not more so, than counselors. After all, they’re in the business of being persuasive.

There’s also this core assumption that banks are unwilling participants in the creation of loans, that only either individuals or government policies could possibly be responsible. This is the exact opposite of how lending works. It’s a partnership between lender and borrower, and only the lender has the advantage of the information from the borrower and the historical data to know whether to take the risk. Underwriting is not performed by a borrower but a lender. They have the responsibility to make good loans that will perform. But you never hear about lender’s responsibilities from people like this.

Zingales cites that this program was suspended for 20 weeks after complaints to legislators. If you want to argue that banks and mortgage brokers have a lot of pull with state legislators, I’ll go ahead and agree. This idea of a citizen revolt because they couldn’t get their mortgages is very powerful on the conservative side – it’s of a piece of the “Community Reinvestment Act caused the financial crisis” theory – but the world simply does not work that way. Legislators respond to their contributors at far higher rates than their constituents. In fact, the industry had major concerns about mandatory counseling, and you can pretty much take it from there. Also, borrowers had to pay for the counseling, and because it was confined to African-American and Latino areas, it took on the appearance of a tax on the poor.

And one credit counseling service, against the mass of fraudulent origination, securitization, and foreclosure documentation that has been demonstrated time and again proves little to me.

Zingales does say “probably there was fraud and the banks need to be sued” before dismissing it as a driving cause. Cherry-picking friendly reports will give that impression, as well as failing to look at the underlying context.

David Dayen

David Dayen