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Information is money

Tim Fernholz wishes conservatives would spend more time thinking through the imbalance in information that's at the heart of most financial transactions:

Consumers are almost always suffering from a major asymmetry in information when they purchase financial products, for reasons both prosaic (lenders inevitably have more experience dealing with these products than the purchasers) and pernicious (banks go out of their way to make loan agreements harder to understand and easier to change without notice; it's very difficult to compare the costs and benefits of different credit products).

Conservative commentators often don't acknowledge these realities; or when they do, usually after buying a mortgage, suggest that it is a failing on the part of the consumer; either they should learn to understand these things or not get credit. But the impact of this information problem is felt by all of us, not just people victimized by bad consumer products, and ignoring it won't make it go away, Nor is there a "free market" solution -- the problems we're seeing, in fact, are the free market solution: Businesses will maximize profit up to the point where there actions are forbidden by law or made prohibitive by cost.

And it's not just consumers. Plenty of transactions between professional investors and banks were based off information asymmetries. That's the process at the heart of the now-infamous Abacus deal, the trade in which Goldman Sachs and John Paulson unloaded some truly toxic mortgage packages on a hapless German investment bank.

What's important to understand about these information asymmetries, however, is that they're features, not bugs. We're not looking at an accidental byproduct of the finance sector. Rather, information asymmetries are how the finance sector makes money.

Consider that the sector's huge profits should be, essentially, impossible. In a working market, competition pushes profits down to almost nothing. To get around that rule, you have to break the market somehow. The pharmaceutical industry does it through patents: It secures temporary monopolies on the sales of its innovations. The financial sector does it through information asymmetries: If you keep your product from being standardized, and you keep your customers from knowing too much about the product, the very complexity of the thing you're selling can give you a temporary monopoly against your competitors, and a massive advantage against your customers. That increases your profits, even as it harms the market and makes it nearly impossible for regulators to do their job.

The question of what to do about all this is rather difficult, though. For a long time, "disclosure" was supposed to be the answer. But for reasons Steve Waldman has explained, that's been a complete failure. Our next effort is Elizabeth Warren's CFPB, at least on the consumer side of things, so I guess we'll just wait and see how that works.

By Ezra Klein  | October 18, 2010; 1:50 PM ET
Categories:  Financial Regulation  
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Comments

it's really quite simple: if you don't understand how the financial product works, don't buy it.

Posted by: jfcarro | October 18, 2010 2:02 PM | Report abuse

"That's the process at the heart of the now-infamous Abacus deal, the trade in which Goldman Sachs and Hank Paulson unloaded some truly toxic mortgage packages on a hapless German investment bank."

Since the Germans more or less co-invented investment banking with the British, AND it was a German investment banker who created the Federal Reserve System, your use of the term "hapless German investment bank" is either satire, or an oxymoron. Which?

Posted by: 54465446 | October 18, 2010 2:03 PM | Report abuse

"it's really quite simple: if you don't understand how the financial product works, don't buy it.

Posted by: jfcarro"

Okay, so because I couldn't calculate how much of my monthly mortgage payment was going toward equity when I bought my house, I should not have bought the house. Perfectly reasonable. Only those who are highly proficient in calculus should own homes.

Posted by: klautsack | October 18, 2010 2:08 PM | Report abuse

"it's really quite simple: if you don't understand how the financial product works, don't buy it."

So, since I don't monitor every in and out of my retirement fund mutual plan, I should put my money in a sock? If I don't research every jot and tittle in a mortgage, I should never buy a house?

We used to trust the government to protect citizens from fraud. Quite obviously that bargain is obsolete. And I'm still trying to figure out whether Ezra's being sarcastic in saying that's a feature, not a bug.

Posted by: stonedone | October 18, 2010 2:11 PM | Report abuse

"Abacus deal, the trade in which Goldman Sachs and Hank Paulson unloaded some truly toxic mortgage packages on a hapless German investment bank"

Do you mean John Paulson? Hank Paulson was working for W by the middle of 2006...

Posted by: justin84 | October 18, 2010 2:14 PM | Report abuse

klautsack,


if you're going to undertake the expense, time, energy to buy a home maybe you should spend time to understand it otherwise renting is a perfectly fine option.

And I'm sorry but no one needs a degree in calculus to understand the complexities in a mortgage. Heck Google mortgage calculator and you'll find a million of them showing you amoritization works.

As far as retirement mutual funds go if you don't want risk most all of them offer a guaranteed interest account you can invest in.

I guess the answer is that we have to dumb down everything to the dumbest person in the room.

Posted by: visionbrkr | October 18, 2010 2:16 PM | Report abuse

stonedone wrote:

"We used to trust the government to protect citizens from fraud. Quite obviously that bargain is obsolete. And I'm still trying to figure out whether Ezra's being sarcastic in saying that's a feature, not a bug."

That is a grade school history view of government (hope that's not too personal) The government is usually on the side of the defrauders and always has been, not the other way around. Occasionally you get some good courts who make decisions to protect consumers, not very often though.

Posted by: 54465446 | October 18, 2010 2:17 PM | Report abuse

The asymmetry of information between buyer and seller is prevalent in nearly every market one can think of. Its probably the most commonly failed "assumption" of free market economics and the one most likely to be ignored by Libertarians as its easy to use it to justify government intervention. I find it especially ironic that Megan McArdle uses it as the name of her pro-Libertarian blog at the Atlantic.

Posted by: Nylund154 | October 18, 2010 2:22 PM | Report abuse

Nylund154 is right. In Economics 101, one of the basic assumptions that everything rests on is that all parties have perfect information. So when you hear commenters on TV talk about the greatness of free markets being "basic economics", remember that "basic economics" also says none of that stuff necessarily holds true if people don't have complete information about what they are buying. So conservatives should be in favor of disclosure, transparency, and simplicity (when possible) more than anyone because those things enable capitalism to work as it is intended.

Posted by: vvf2 | October 18, 2010 2:30 PM | Report abuse

vvf2:

Yes, of course but that's a non-existent world. We teach more about biology, chemistry and algebra in high school than we do about business, even though most of use some form of business every day, but chemistry??????

I tell every high school graduate I care about to watch CNBC, Fox Financial, or Bloomberg for 5-10 minutes a day, everyday. Doesn't even matter what show. In the beginning, you won't know what on earth they're talking about. It's like total immersion language training though, soon you begin to get the picture.

Posted by: 54465446 | October 18, 2010 2:48 PM | Report abuse

There are a bunch of deeper issues to consider here:

1) Complex financial instruments are often demanded by clients of big banks in order to hedge against complex financial risks. This isn't purely a case of suppliers of assets trying to maintain monopoly power.

2) Even complex instruments may be replicated when shorting is possible. The source of monopoly power in some instances isn't complexity itself, but other market frictions.

3) Economists are used to talking about asymmetric information resulting from private signals about the state of the world. Klein appears to mean something different - asymmetry here is over the contract terms and payoffs of securities in different states of the world.

Posted by: nmph | October 18, 2010 2:52 PM | Report abuse

oh, i'm all in favor of more disclosure and transparency. most people don't read the forms, as ezra notes above.
and yes, figuring out which part of your payment goes towards equity is a pretty basic requirement. i do that for my student loans (which are about the size of an average mortgage). and if you dont understanding investing at all, there are lots of guaranteed return investments that don't require any understanding at all.

Posted by: jfcarro | October 18, 2010 2:54 PM | Report abuse

visionbrkr -

Using an online mortgage calculator is completely different from understanding amoritization.

Also, when I began the process of buying a house I went to see a mortgage broker and they did an initial assessment of how big of a loan they'd be willing to float my way based on income, levels of debt, credit score, etc. The figure they came back with was a good 40 % higher than what I was comfortable with. But you have that moment where you're like "maybe I calculated something wrong". And this was in the summer of 2009 when everything was still basically in freefall. And here they were putting it in my head that I, too, could own 40 % too much house. What's it to them? If I fall behind in my mortgage payments, they foreclose, sell the house again, and then come after me for the difference.

Posted by: klautsack | October 18, 2010 2:55 PM | Report abuse

"Okay, so because I couldn't calculate how much of my monthly mortgage payment was going toward equity when I bought my house, I should not have bought the house. Perfectly reasonable. Only those who are highly proficient in calculus should own homes."

klautsack,

It's not difficult. Spend 10 seconds on Google and you'll find an array of mortgage payment calculators. I'll bet there's even an app for it!

http://www.bankrate.com/calculators/mortgages/amortization-calculator.aspx

You can also build your own amortization table in excel:

http://office.microsoft.com/en-us/excel-help/using-the-loan-amortization-and-loan-analysis-templates-HA001034640.aspx

You don't really need to know the precise dollar amount of principal you pay off (it's always a small percentage early on), and the math isn't calculus:

Equity contribution = Monthly Loan Payment - (Interest Rate / 12 * Remaining Principal Balance)

But anyway, you don't need to be a genius in order to finance a home.

You need to know how much they are asking you to pay each month, whether or not you can afford it, whether or not the payment is fixed (and if you can afford it the payment rises), and whether or not you are getting a good deal.

It's not much different from buying a car. If you don't do any research and immediately buy at the first dealership you walk into, you will probably be taken. Same with buying a house. But that's life.

If you are buying something worth hundreds of thousands of dollars, its best to take a little time and make sure it is done right.

"We used to trust the government to protect citizens from fraud. Quite obviously that bargain is obsolete. And I'm still trying to figure out whether Ezra's being sarcastic in saying that's a feature, not a bug."

stonedone,

Fraud should be prosecuted.

However, the government shouldn't try to make it so easy and "safe" so that consumers let their guard down and just assume things will be fine without doing their homework.

The government won't do the job perfectly and a lot of the trusting souls will be out of a good deal of their hard earned cash.

Ezra is saying that opacity is a feature from the perspective of the financial firms.

"So, since I don't monitor every in and out of my retirement fund mutual plan, I should put my money in a sock?"

Not every in and out, but you should have a basic knowledge of what's going on.

What you are investing in? What fees do you face? Can you get a better deal elsewhere?

If you don't understand what is going on, there are plenty of books out there. You might need to spend a few hours educating yourself, but its your retirement after all. Probably worth the time. You could also talk to friends who know a bit more about the subject.

Posted by: justin84 | October 18, 2010 3:06 PM | Report abuse

Another approach would be to enforce antitrust laws against Wall Street investment banks. I would submit that Goldman Sachs is as much of a threat to the republic as Standard Oil, AT&T & Microsoft were. See Matt Taibbi in Rolling Stone for numerous examples.

The best critique I have read regarding the lack of market competition in the investment banks is Steve Pearlstein's:

"A handful of established firms control access to global financial markets and use this power to extract monopoly-like profits and funnel them to their executives and employees.

The reason for the lack of price competition is pretty simple: The banks know that if they start offering big discounts, all their rivals will be forced to do the same. In the end none of them would gain a competitive advantage, but all of them would wind up with less money. The only winner from a price war would be their customers.

This kind of cozy competition only works in markets where it is virtually impossible for upstart firms to gain a foothold by offering a lower price."

http://www.washingtonpost.com/wp-dyn/content/article/2010/08/19/AR2010081906574.html

Also, the conservative/libertarian response to the information asymmetry issue would probably look something like Paul Ryan's response to the benefits of health care competition accruing, even for those who aren't experts:

"EK: You’re arguing that the benefits of competition accrue, and so even if you don’t choose at the moment of emergency, there’s still an effect from a higher-functioning market.

PR: Absolutely. I don’t know anything about cars. I look at Consumer Reports and their ratings. What matters is that someone who knows about cars went and figured this out. The car company is competing for the really tough customer who goes under the hood. I’m not saying every American has to be that consumer. But enough people have to so the rest of us can benefit."

http://voices.washingtonpost.com/ezra-klein/2010/02/rep_paul_ryan_rationing_happen.html#comments

Posted by: jnc4p | October 18, 2010 3:06 PM | Report abuse

@klautsack,

Any sensible person if they were given a "pie in the sky" figure would have stopped and said well let me go through my budget. What do i have coming in, what do i have going out etc and then build in some cushion. If people in that instance take on too much risk then that's their fault and if their mortgage broker is pushing it too hard then go find someone else who won't push the envelope as much. As with anything else if you're not comfortable with who you're buying a product as important as a mortgage you'd better keep looking until you can find someone you can trust.

if you think "maybe I calculated wrong" then simply ask him or her. If they're evasive in their answers then that's a good clue to go somewhere else and tell that person of your last bad experience first off so they don't go down that path.

I'm sorry but I don't buy this "poor homeowner crap" unless someone is being intentionally fraudulent and then they need to go to jail for it or face stiff penalties to stop it. At some point we have to be a little responsible for our own actions. If you don't know how much house you can afford then you need to do some more homework (which it sounds like you did).

Posted by: visionbrkr | October 18, 2010 3:10 PM | Report abuse

Also, if you want to fix the mortgage system so that this can never happen again, just outlaw the securitization of mortgages. If banks are forced to hold the mortgages they write, they will do a better job of evaluating credit worthiness, and if they don't it will be a lot easier to clean up the mess the next time around.

Posted by: jnc4p | October 18, 2010 3:11 PM | Report abuse

"The question of what to do about all this is rather difficult, though"

For starters, don't bail out Goldman Sachs next time.

Posted by: bgmma50 | October 18, 2010 3:45 PM | Report abuse

"Using an online mortgage calculator is completely different from understanding amoritization."

klautsack,

You can google that too. Or buy a book.

A home is a big purchase after all. People spend hours researching cars that costs 1/10th of what a home does and that are typically owned for a shorter period of time.

Amortization just isn't that tough of a concept. All it means is paying down the balance of the loan.

As the loan is paid off, the interest portion of the payment goes down (lower balance, same rate) and the principal portion goes up. It's calculated so that the total payment is at the same level each month.

"The figure they came back with was a good 40 % higher than what I was comfortable with."

Well sure, they were going for the size of the loan they felt comfortable making. While it's tempting to get the larger house, it sounds like you had a pretty good idea of what was affordable.

Any adult should be able to make a budget and figure out what amount would be reasonable for mortgage payments given other expenses and savings.

Posted by: justin84 | October 18, 2010 3:48 PM | Report abuse

"If banks are forced to hold the mortgages they write, they will do a better job" posted by jnc4p

So true. But of course then Barney Frank will be all over the lenders because they won't loan money to people who can't pay back their loans.

Posted by: bgmma50 | October 18, 2010 3:53 PM | Report abuse

Just when I thought someone couldn't outdo the naivete of Ezra, klautsack manages to pull it off with little trouble.

Posted by: novalifter | October 18, 2010 4:04 PM | Report abuse

justin84 -

But the point is that you rely upon a book, or google search, or a broker, to get an idea of what people around you are spending on houses to understand how to do things. The idea that you should never purchase something unless you understand how it works (kindle, anyone?) is absurd. Practically everything we do relies upon someone else's expertise.

Posted by: klautsack | October 18, 2010 5:45 PM | Report abuse

An article in the NYT today illustrates both the problem of information imbalance, and unequal bargaining power:
http://www.nytimes.com/2010/10/18/business/18advantage.html?ref=business

The banks push pension funds into securities lending, by telling them they'll raise fees if they don't agree to the contract. Then the contract tells them that they share profits, but that the pension fund bears liability for all losses. The bank will not let them negotiate any other arrangement. Meanwhile, the bank has used its information to pull out of a related deal, but doesn't share that information with the pension fund. Then the pension fund loses big. And they can't just take their account to another bank without paying their losses first.

As I read this article, I was reminded of a case we read in law school, where the coal company would set up a store in the company town. They would charge a premium for items, and would allow people to charge beyond their ability to pay. And the paychecks were never enough to cover the balance owed at the store. And they couldn't quit and move, because they owed the company money. A court said that practice was unconscionable.

I wish I had the same faith in the courts to do that with modern financial instruments, because it sure smells rotten.

Posted by: reach4astar2 | October 18, 2010 6:42 PM | Report abuse

It is fantastic time to refinance home mortgage. As Clark Howard says it is very tough to find these low rates for long time. Search online for "123 Mortgage Refinance" they found me THE lowest possible rate.

Posted by: rachelbilson19 | October 19, 2010 6:16 AM | Report abuse

I find the analogy between pharmaceuticals and bankers a gross mismatch. Bankers sell treacherous financial products at best and hot air at worse. Whereas pharmaceuticals have put lot of money and effort in their products, products that can cure ppl.

Posted by: Trouderenard | October 19, 2010 12:45 PM | Report abuse

I find the analogy between pharmaceuticals and bankers a gross mismatch. Bankers sell treacherous financial products at best and hot air at worse. Whereas pharmaceuticals have put lot of money and effort in their products, products that can cure people.

Posted by: Trouderenard | October 19, 2010 12:47 PM | Report abuse

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