“I can tell you for a fact, pre-crisis, the folks at IndyMac (me included) thought we were doing both good for U.S. homeowners/borrowers, good for the economy (by supporting the government’s housing goals) and good for ourselves. It’s tough to decide what the right types and amount of home mortgages to make. Post-crisis, with the benefit of hindsight, the banking, mortgage, and consumer regulators took years and in the end they didn’t really decide…
…Why is it so tough, even with the benefit of hindsight? You have to ask and answer a lot of very tough questions. Are we making mortgages to support the overall U.S. economy and jobs or are we making mortgages so that very few home borrowers ever fail? Those two goals are (mostly) mutually exclusive. Are we making mortgages that assume nominal, national home prices never fall? (They have only done so twice in the past 100 years….during The Great Depression and The Great Recession of 2008.) That was the assumption pre-crisis, if it’s not the assumption post-crisis, how can the government continue to prudently guarantee or insure mortgages with little-to-no down payments? I could go on and on, but I think most understand. It’s not easy. It’s complicated.”, Mike Perry, former Chairman and CEO, IndyMac Bank
“It is worth noting that the Dodd-Frank Act tasked several agencies (the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), the SEC, the Federal Housing Finance Agency (FHFA), and the Department of Housing and Urban Development (HUD), with the responsibility to develop a “qualified residential mortgage” (QRM) that is, a mortgage of such quality that it would present a very low risk of default. To meet this standard, the agencies originally developed a mortgage with the same three underwriting constituents that had characterized the traditional prime mortgage: a substantial down payment on purchase money loans (20 percent), a DTI ratio after the mortgage of 36 percent, and strong credit history (the agencies did not use FICO scores per se). However, succeeding events show that the lessons of the financial crisis had not been learned. The proposed rule met with a substantial outcry from what might be called the “government mortgage complex….Realtors, banks, and community activists….who contended the down payment and other provisions would deprive low-income borrowers and others of a chance to buy homes. Lawmakers who had voted for the QRM quickly reversed themselves in the face of this opposition and called on the agencies to repropose a more lenient rule. In August 2013, accordingly, the agencies succumbed to this pressure and published a new proposal for QRM. This one abandoned any reference to traditional underwriting standards for a prime or low-risk loan and adopted as the standard a minimum mortgage standard proposed in January 2013 by the Consumer Financial Protection Bureau. The standard did not require any particular down payment or credit record, and the agencies admitted in their reproposal that, by 2012, mortgages meeting this standard between 2005 and 2008 had experienced serious delinquency or default at a 23 percent rate. The agencies also made their motivations clear when they noted that they were “concerned about the prospect of imposing further constraints on mortgage credit availability at this time, especially as such constraints might disproportionately affect groups that have been historically disadvantaged in the mortgage market, such as lower-income, minority, or first-time homebuyers. The rule was finalized in October 2014.”, Peter J. Wallison, Hidden in Plain Sight: What Really Caused the World’s Financial Crisis and Why It Could Happen Again”, 2015
Why a Harvard Professor Has Mixed Feelings When Students Take Jobs in Finance
By SENDHIL MULLAINATHAN
This is a bittersweet time on campus. Seniors are beginning to find jobs, and while their enthusiasm is infectious, some of their choices give me pause.
Many of the best students are not going to research cancer, teach and inspire the next generation, or embark on careers in public service. Instead, large numbers are becoming traders, brokers and bankers. At Harvard in 2014, nearly one in five students who took a job went to finance. For economics majors, the number was closer to one in two. I can’t help wondering: Is this the best use of talent?
Of course, these are intensely personal choices as young people chase their aspirations and dreams. But if a favorite student of mine comes up to me and says, “I just got an offer at this investment bank and I’m going to take it,” I want to know how should I feel about it. I will be happy for her individually, but still I wonder: Is this a good decision for society as a whole?
As an economist, I look at it this way: Every profession produces both private returns — the fruits of labor that a person enjoys — and social returns — those that society enjoys. If I set up a shop on Etsy selling photographs, my private returns may be defined as the revenue I generate. The social returns are the pleasure that my photographs provide to my customers.
A scene from “It’s a Wonderful Life” that presents two types of bankers. Mr. Potter, seated, played by Lionel Barrymore, pursues only personal gain, while George Bailey, played by Jimmy Stewart, helps workers in his community buy homes. Credit Bettmann/Corbis
People in some professions provide a surplus of social returns. Inventors are a good example. Take the modern semiconductor. It made possible countless other inventions — nearly every piece of computing we interact with today.
But the winners of the 1956 Nobel Prize in Physics, John Bardeen, Walter H. Brattain and William B. Shockley, who have been widely credited with inventing the semiconductor, did not receive even a fraction of the wealth that their invention would help create. Patents rarely cover an invention’s numerous downstream benefits because knowledge is a public good and builds on itself. Just as the semiconductor spawned innovation, Bardeen, Shockley and Brattain themselves relied on countless other insights and inventions.
It is important to remember that it is not just inventors, teachers or nonprofit workers who provide more social than private value. This is an economic insight as old as Adam Smith: Thanks to the division of labor, in a well-functioning market we can do our own thing and still contribute to the greater good. Inventors may be supervalue-adders, but most of us add value, albeit to a lesser degree. This is a comforting power of markets: We can do good for society simply by doing what we do well.
But not everyone contributes in this way. In an influential paper, the economists Kevin M. Murphy and Robert W. Vishny, both at the University of Chicago Booth School of Business, and Andrei Shleifer at Harvard University argue that countries suffer when talented people become what we economists call “rent seekers.” Instead of creating wealth, rent seekers simply transfer it — from others to themselves.
Job titles don’t tell you whether someone is primarily a rent seeker. A lawyer who helps draft precise contracts may actually be helping the wheels of commerce turn, and so creating wealth. But trial lawyers in a country with poorly functioning tort systems may simply be extracting rents: They can make money by pursuing frivolous lawsuits.
In this respect, finance is a vexing industry. Take arbitrage — a common way to make money in finance. Find a stock that should be valued at $15 but that is trading at $10, buy it, wait and hope. You might assume that stock markets are just a big casino, in which skilled traders extract money.
But arbitrageurs can create value, and stock markets can play an important social function. They determine which companies receive capital cheaply and which pay a heavy price for it, determining where factories are built, which retail stores are expanded and where research and development happens. Mispriced stocks can mean misplaced investments. Arbitrageurs help get the prices right, and that’s important.
Still, arbitrage is valuable only to a point. It has a gold rush element with prospectors racing to get to the gold first. While finding gold has value, finding gold before someone else does is mainly rent-seeking.
The economists Eric Budish at the Booth School of Business and Peter Cramton at the University of Maryland, and John J. Shim, a Ph.D. candidate at Booth, have shown in a study how extreme this financial gold rush has become in at least one corner of the financial world. From 2005 to 2011, they found that the duration of arbitrage opportunities in the Chicago Mercantile Exchange and the New York Stock Exchange declined from a median of 97 milliseconds to seven milliseconds. No doubt that’s an achievement, but correcting mispricing at this speed is unlikely to have any real social benefit: What serious investment is being guided by prices at the millisecond level? Short-term arbitrage, while lucrative, seems to be mainly rent-seeking.
This kind of rent-seeking behavior is widespread in other parts of finance. Banks sometimes make money by using hidden fees rather than adding true value. Debt collection agencies may use unscrupulous practices. Lenders to poor people buying used cars can make profits with business models that encourage high rates of default — making money by taking advantage of people’s overconfidence about what cars they can afford and by repossessing vehicles. These kinds of practices may be both lucrative — and socially pernicious.
But finance need not be this way. George Bailey, the protagonist in the classic film “It’s a Wonderful Life,” was a banker. When he was reluctant to take the job, his father explained to him: “You know, George, I feel that in a small way we are doing something important. Satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things.”
George Bailey’s father realized that finance has the ability to do great good. And he was right. The poor face a tremendous problem every day juggling money and expenses. Their pay often fluctuates week by week, yet they must pay rent no matter what they earn. Right now, poor people often use expensive payday loans or must incur expensive late fees.
Surely we could do better. Finding ways to smooth out these shocks is the kind of important, socially valuable problem that finance could solve. Many other crucial social problems have finance at their root, from saving for college to insuring unemployment risk.
Instead of finding clever ways to hide fees, banking innovations could solve these real and important problems. In much of the developing world, we have already come to associate finance with creative ways to lend to the poor or to offer microinsurance products that protect farmers against uncertain rainfall. There is no reason we cannot have a similar wave of positive financial innovation in the United States.
So how should I feel about my students going into finance? I hope they realize that they have the potential to do great good and not simply make money. It may not be how the industry is structured now, but idealism and inventiveness are two of the best traits of youth, and finance especially could use them.
Sendhil Mullainathan is a professor of economics at Harvard. Follow him on Twitter at @m_sendhil.
A version of this article appears in print on April 12, 2015, on page BU6 of the New York edition with the headline: Maximizing the Social Returns of a Career in Finance