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Money, Mortgages, Morality, Entrepreneurship, and A Free Lunch (commentary-opinion)

The subprime mortgage crisis has led to investment portfolio losses in great companies like Citibank and other public companies like MoneyGram. Stock prices fall and individual investors take a hit when these companies are forced to write down the value of their investment portfolios.

Why does America have a subprime mortgage crisis? In my view, it comes down to two simple facts. One, a lack of ethics and morality in the people who pushed these mortgage vehicles to investors and who sold the mortgages in the first place. Two, a lack of attention to government regulation by Alan Greenspan and a silly philosophy that free markets will be self-correcting on ethical issues.

Some mortgage loan originators and real estate agents encouraged new homeowners to take on larger mortgages than they could afford. Worse, to disguise the costs of these mortgages, many pushed adjustable rate mortgages to unsuspecting consumers. When interest rates rise, the new homeowners find they can't afford their mortgage. This has contributed greatly to an economic mess that might well lead to an American recession.

The moral hazard in this is that the loan originators and the real estate salesmen make their commissions and can usually walk away regardless of what happens down the road. These mortgages are bundled together and sold to investors as mortgage-backed securities. There was little incentive for those selling the loans to seriously evaluate whether or not the consumer could pay the loan in the long run. In the worst cases of fraud, those selling the loans knew the consumers had little chance of meeting their payments but misled the consumers into believing the housing market would always rise and the loan could always be refinanced. If each loan originator and real estate agent in these transactions had been forced to keep their wealth invested in the mortgages they sold, it's unlikely we'd have a subprime mortgage crisis today.

Other factors certainly contributed to the subprime mortgage crisis. Too many jumped on the real estate investment bandwagon. While many knowledgeable investors made money flipping properties, as with many manias, too many investors saw easy profits by investing in houses for quick resale. Many single-family homes were not owned by a family who planned to live there, but were owned by a wanna-be real-estate mogul looking to sell it quickly. These properties were often highly leveraged.

The American consumer isn't fully blameless either. Many jumped into homes they couldn't afford. Amazingly, we're told some gleefully removed cash from the financing deal. The whole system of credit checking broke down because breaking the system served the interests of too many who could profit from a broken system. And, alas, many Americans, feeling richer because their houses had a higher market value, took out home equity loans and spent the money. Why they thought this made sense is a mystery to me.

This brings us back to Citibank. How does a reliable credit card company lose money? It seems to violate a law of nature or something. Some investors will point fingers at the executives. Many of the executives at these large companies point their fingers at the debt rating system. It seems these professional investors should have seen the dangers inherent in over-investing in mortgage-backed securities. But, hindsight is usually 20-20. Ultimately, it seems the executives at these larger companies, always a possible punching bag when things go wrong, are largely blameless. Except, of course, that they could have paid far more attention to the securities in which they were investing.

In Becoming An Investor: Building Wealth By Investing In Stocks, Bonds, and Mutual Funds, I write that banks are a great investment, because they're in the business of selling money for more than it's worth. I also point out the near impossibility of the average investor evaluating the quality of the loans the bank is making. This means what is fundamentally a sound business creates a risk for retail investors who don't have a full view into the operations of the bank.

So, it appears a great (mostly) American company, Citibank, must now go with its hat in its hand (metaphorically speaking, of course) and seek financing from wealthy investors in foreign countries, primarily the oil-rich countries in the Middle East. High oil prices have left the powerful elite in the oil-producing world relatively well-off. Fortunately, most oil transactions are still priced in American dollars. The falling dollar (relative to other currencies) means other foreign investors will pick up distressed American companies on the cheap.

The dilution of ownership of American investors in companies desperately seeking financing abroad isn't a positive development for long-term, buy-and-hold American investors. Some professional economists argue this foreign investment is a positive thing, because without it the companies could suffer far greater problems. And, historically, it appears Arab investors have been reliable buy-and-hold investors who don't try to unduly influence corporate policy. But for all current stockholders, American and foreign alike, equity dilution often isn't desirable.

Ironically, even while China scoops up positions in American banks, it appears Chinese banks are being bitten by the American subprime debacle (Just how many crappy home loans are out there?). And, the Chinese have another worry. It's largely American consumerism that has fueled China's growth. If Americans tighten their financial belts, that's not good for China.

The second reason America has a subprime mortgage mess is because under the Bush administration and the leadership of Federal Chairman Alan Greenspan, our government hasn't aggressively sought to protect consumers (and average investors) from predatory lending. It hasn't sought to keep the markets operating with high integrity.

Now, of course, Greenspan has done an outstanding job with monetary policy. But, he's not a believer in government regulation. Several regulators saw how the subprime crisis could unfold and were apparently brushed off by Greenspan, because preemptively dealing with the situation would have required tightened regulations on the subprime market. Regulation just wasn't a tool Greenspan liked using.

When I was younger I also believed in this concept of the markets being self-regulating. It seemed to make a certain logical sense. If a company is behaving badly and that is exposed to the public, we might think the company would be forced to change its ways or go out of business. And, fortunately, it does work this way for some businesses. Especially for small, locally-owned businesses serving the local community. But, it doesn't work for all businesses. And, it certainly doesn't work this way for most large, international companies. This Ayn Rand view of capitalism dismally fails in practice in our modern globalized world.

Without government regulations, nefarious businesses seeking to earn more will harm the consumer and in many cases get away with it. These companies will maximize their own profits while minimizing any concern for the overall good of their consumers, their suppliers, America, or the world. Government regulations obviously set the line as to what is legal in pursuing profits.

In listening to an interview with David Cay Johnson, author of Free Lunch: How the Wealthiest Americans Enrich Themselves at Government Expense and Stick You with the Bill, Johnson says certain lending practices today would have been considered illegal in the past. Supposedly legitimate companies sell payday and other loans to the poorest Americans at rates of interest that would make a mafia loan shark blush.

Johnson argues a pattern of change in American government and law is designed to allow the super rich to exploit poorer and middle-class Americans. It's a change that benefits the less ethical. While some argue deregulated rates of interest allow more people to borrow money, we should ask: If you're charging a poor person 25% rate of interest on a loan, are you really helping that person? Or are you just exploiting them? Perhaps restoring usury laws is a good idea.

It's really a question of deciding what kind of America we want in the future. Do we want a free-for-all market system where regulation is minimized and companies are free to seek to profit in any way even if it ultimately damages America? Or do we want a more balanced system where unethical behavior is shut down? Among the Presidential candidates, the only one who honestly addressed this was John Edwards, who is now out of the Presidential race (and, to a lesser extent, Republican John McCain and Democrat Hillary Clinton). The Presidential candidates, Democrat and Republican alike are both afraid of confronting and displeasing the wealthy corporate elite. Political power hinges on getting support from these corporate interests. Because of the profits involved, we'll probably never see the elimination of adjustable rate mortgages, balloon payments, and other "creative" loans. America would do well with just straight 15-year and 30-year fixed mortgages where maximum interest rates were set by the government. Leave the creativity to artists and musicians.

Any discussion of limiting interest rates on loans to protect American consumers invariably brings up the topics of microlending and financial education.

Americans should be taught far more about money, investing, compounding, consumer rights, and the true cost of borrowing money. This education is especially needed in poorer areas. When poor people pay excessive interest for consumer purchases, for payday loans, and other fees of a dubious sort, that doesn't offer a service. It's just a way for corporations to pocket more money. These "high-risk" (and high profit) lenders argue that traditional banks have abandoned these areas. They see themselves as providing a service. It might sound odd, but what is a community without a community bank?

Microlending involves making smaller loans to people in poorer countries. Kiva.org has generated some publicity as an online place where individuals can make small loans to people in poorer countries. Often these loans are made to help a poorer person start a modest community business--buy a goat or something. (Of course, great care should be taken when considering such a loan, because opportunities for fraud abound. I'm not familiar with any of the online microlending sites and am not endorsing [nor dis-endorsing] them.)

Previously, microlending was seen as a method of social entrepreneurship, In 2006, the Nobel Peace Prize went to Muhammad Yunus who helped to pioneer the idea in Bangladesh. Microlending has also contributed to development in Africa. By American standards, interest rates on these loans are quite high (typically 30% or more), because the costs of processing such small loans (often on the order of $100 or less) is high. To much of the world, $100 is a whopping fortune. It appears that these loans have made a real difference in helping the world's poor build small businesses. This is because the money isn't squandered but put to real use. A sewing machine, a goat, a cart, a washing machine, or other capital investment can justify the rates of interest because of the high value of adopting this operational change.

But, such a concept is obviously open to abuse. BusinessWeek published a good article titled: "The Ugly Side of Microlending: How big Mexican banks profit as many poor borrowers get trapped in a maze of debt." The article posed the question: Were some of these lenders more interested in getting loan shark rates of interest than making a social difference? At what interest rate does offering loans cease helping and become loan sharking?

We face the same danger of excess today with online microlending. If microlending moves from social entrepreneurship into for-profit entrepreneurship, that changes the dynamic. Social entrepreneurs use business methods to bring about positive social change.

Rather than people risking a small amount, they might start looking at microlending as a way to earn a high return. Then, the profit motive moves in and pushes out the initial motivation for making these loans in the first place. Suddenly, we'll have microloan moguls, bundled goat loans, and every poor person from Tanzania to Haiti will seek shack-improvement loans. The "service providers" and loan originators will run amuck seeking more and more transaction fees. The evaluation of the loan and its reasonableness will go out the window. More loans would mean more transaction fees. This will destroy the credibility of the microlending process. What started as a legitimate service can be destroyed by greed. With a new globalized world will no doubt come new world-wide manias. But, human nature will remain the same.

As entrepreneurs and investors, we can seek to profit and protect ourselves from these manias and changes. We can anticipate them and act accordingly. But, we should always keep in mind the ethical and moral issues and not blindly accept the big-business maxim that all regulation is bad.