The Dangers of Mixing Business, Government, and Good Intentions: Remembering Uncle Milton

Milton Friedman is mocked in the world of ethics for his unwavering conviction that the primary responsibility of business is to make money. Mix good intentions, i.e., social responsibility, with profit motives, Dr. Friedman warned, and you tinker with market forces. Tinker with market forces and you net perverse outcomes. With the markets reeling, the naive cry of “Greed!” as causation consumes the land. But one-seventh of the deadly sins can be curbed. Stoking its flames is risky. The subprime loans stoked the economy and led to the crisis in the financial markets. But one has to ask, “Why would lenders make such risky loans in the first place?” Subprime loans, are, by definition, high-risk, low-quality loans. Well, good intentions with a little mandate from the federal government, may have given lenders the perverse incentive to dabble in bad investments. The Community Reinvestment Act is a federal statute that established a government program to get people who would otherwise not qualify (i.e. no credit history and no down) into homes with the goals of helping these folks and thereby revitalizing blighted areas. Everyone felt terrific about banks and other lenders making this commitment to their communities, ‘We’re revitalizing, don’t you know! Doing well by doing good.” Banks and lenders were evaluated for their commitment to these loans, and no bank or lender wanted a bad rating, something that said you were a cold and heartless institution that didn’t care about its community and was driven only by profits.

Simultaneously, the Feds anticipated push-back from lenders who would point out that these were high-risk loans and required greater returns. So, through other statutes the Feds exempted the loans from state maximum interest rates. The effect was to banish the market’s logic of not making bad loans. They made the loans, loans with interest rates that, ironically, forced the beneficiaries into a struggle to pay from the get-go. The lenders were not permitted to respond to the Feds when they were given poor ratings under CRA evaluations that the reason they had none of these loans because, well, the folks just didn’t qualify. Indeed, part of their evaluation for their CRA commitment included their creativity in granting the loans. Downey Savings and Loan, now teetering on receivership, had loans under which borrowers got to choose how much their initial mortgage payments would be. Downey just kept rolling all the deferred interest into principal. These bad-credit-risk borrowers finished with loans that exceeded property values by the time they began making what the real payments would be.

Also, the Downey loans were ARMS, so when the real payments (i.e. true cost of the mortgage loan) kicked in and interest went up, well, there was a bit of the old loan sticker shock. There was also an exacerbating effect of this false sense of security on the part of the high-risk borrowers about their mortgages. Because these risky borrowers were not really anteing up the actual cost of their homes (and remember these were folks who had never had a mortgage before, had bad credit histories, and may not have had much in the way of financial literacy), they overextended and overspent in other areas. In short, they were maxed out in all areas because they were lulled into a sense of false financial security with such a low mortgage payment. When markets don’t reflect true costs, we overuse and overspend.

These souls, the beneficiaries of well intentioned, albeit misguided, noblesse oblige, had no savings cushion, no grasp of reality, and little appreciation for what had been handed to them, a universal side effect when folks are given something for nothing. So, with federal intervention and dedication to social responsibility, banks made bad loans, Fannie bought and packaged them, and, well, the rest is financial history.

However, there is rich irony not covered in the business press. As we might predict with an understanding of markets and risk, foreclosures were rampant under these CRA loans. Further, most of the CRA loans were in the same areas, those areas targeted for beneficence via federal mandate. Cleveland and Baltimore, plagued with neighborhoods full of boarded homes, have brought suit against the lenders who made these loans because the effect has been to create or exacerbate blighted areas. Foreclosure areas have run-down homes and high-crime because of so many empty, abandoned, and foreclosed properties. The CRA and all its good intentions actually brought us back to the same, perhaps worse, conditions than those it was designed to remedy.

Oh, watch those good intentions. Our efforts would have been better spent on skills training for low-income individuals. Maybe even some help with financial literacy — educational opportunities for understanding credit extension, terms, and repayment. If you want better communities, work to provide the opportunities for earning income and down payments. Then let those who benefit from these programs take their savings and steady income and qualify for loans under the same standards. Waive the market-established standards for lending and you live through the ripple effects we are now experiencing. Only the ripple is a bit of a tidal wave. That tidal wave is what we get when we pursue social responsibility by tampering with market forces.

About mmjdiary

Professor Marianne Jennings is an emeritus professor of legal and ethical studies from the W.P. Carey School of Business at Arizona State University, retiring in 2011 after 35 years of teaching undergraduate and graduate courses in ethics and the legal environment of business. During her tenure at ASU, she served as director of the Joan and David Lincoln Center for Applied Ethics from 1995-1999. In 2006, she was appointed faculty director for the W.P. Carey Executive MBA Program. She has done consulting work for businesses and professional groups including AICPA, Boeing, Dial Corporation, Edward Jones, Mattel, Motorola, CFA Institute, Southern California Edison, the Institute of Internal Auditors, AIMR, DuPont, AES, Blue Cross Blue Shield, Motorola, Hy-Vee Foods, IBM, Bell Helicopter, Amgen, Raytheon, and VIAD. The sixth edition of her textbook, Case Studies in Business Ethics, was published in February 2011. The ninth edition of her textbook, Business: lts Legal, Ethical and Global Environment was published in January 2011. The 23rd edition of her book, Business Law: Principles and Cases, will be published in January 2013. The tenth edition of her book, Real Estate Law, will also be published in January 2013. Her book, A Business Tale: A Story of Ethics, Choices, Success, and a Very Large Rabbit, a fable about business ethics, was chosen by Library Journal in 2004 as its business book of the year. A Business Tale was also a finalist for two other literary awards for 2004. In 2000 her book on corporate governance was published by the New York Times MBA Pocket Series. Her book on long-term success, Building a Business Through Good Times and Bad: Lessons from Fifteen Companies, Each With a Century of Dividends, was published in October 2002 and has been used by Booz, Allen, Hamilton for its work on business longevity. Her latest book, The Seven Signs of Ethical Collapse was published by St. Martin’s Press in July 2006 and has been a finalist for two book awards. Her weekly columns are syndicated around the country, and her work has appeared in the Wall Street Journal, the Chicago Tribune, the New York Times, Washington Post, and the Reader's Digest. A collection of her essays, Nobody Fixes Real Carrot Sticks Anymore, first published in 1994 is still being published. She has been a commentator on business issues on All Things Considered for National Public Radio. She has served on four boards of directors, including Arizona Public Service (1987-2000), Zealous Capital Corporation, and the Center for Children with Chronic Illness and Disability at the University of Minnesota. She was appointed to the board of advisors for the Institute of Nuclear Power Operators in 2004 and served on the board of trustees for Think Arizona, a public policy think tank. She has appeared on CNBC, CBS This Morning, the Today Show, and CBS Evening News. In 2010 she was named one of the Top 100 Thought Leaders in Business Ethics by Trust Across America. Her books have been translated into four different languages. She received the British Emerald award for authoring one of their top 50 articles in management publications, chosen from over 15,000 articles. Personal: Married since 1976 to Terry H. Jennings, Maricopa County Attorney’s Office Deputy County Attorney; five children: Sarah, Sam, and John, and the late Claire and Hannah Jennings.
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8 Responses to The Dangers of Mixing Business, Government, and Good Intentions: Remembering Uncle Milton

  1. J-WIld says:

    I am wondering if you could comment in light of your post about the findings of a study done by Traiger and Hinckley regarding the CRA’s that found the exact opposite effect of CRA’s on banks and lenders than what you are proposing. The summary conclusion of that study was as follows:

    CRA Banks were substantially less likely than other lenders to make the kinds of risky home purchase loans that helped fuel the foreclosure crisis. Specifically:
    1. CRA Banks were significantly less likely than other lenders to make high cost loans.
    2. The average APR on high cost loans originated by CRA Banks was appreciably lower than the average APR on high cost loans originated by other lenders.
    3. CRA Banks were more than twice as likely as other lenders to retain originated loans in their portfolio.
    4. Foreclosure rates were lower in MSA’s with greater concentration of bank

    Here’s the link to the study for further reading.

  2. J-Wild says:

    So no reply? Will this convince you that you were wrong?

    Ronald D. Utt, Ph.D. Heritage Foundation:

    Time to Reform Fannie Mae and Freddie Mac (2005).

    “Despite its claims to the contrary, Fannie Mae’s basic operating procedures do not target any particular type of buyer/borrower….Nine percent of the conventional conforming loans made by the private mortgage market were to first-time minority homebuyers. By contrast, only 4.7 percent of Fannie Mae loans and 3.5 percent of Freddie Mac loans over the same period were to first-time minority homebuyers.”

  3. mmjdiary says:

    Not a tough response here — 2005? You might need some data on the subprime frenzy — not even warmed up in 2006. Check the profiles of the CDOs Fannie sold.

    Odd that the Heritage Foundation is defending a government-subsidized agency — takes all the risk but does not bear the consequences???

  4. mmjdiary says:

    On the T & H study — I cannot always respond daily to posts. I do have a day job!

    Now, let’s think about 2 things:

    1. The study was conducted by a law firm that specializes in, ta-da- providing counsel to fair-lending institutions! If the CRA goes, well, a new line of work will be required.
    2. The study, by its own admission, does not cover all CRA lenders — read the first page. It is a highly selective study that suffers from one more problem — we don’t know the CRA bank’s ratings, do we? In other words, even if we delve into the loans and give T & H its hypothesis as an unassailable proposition, we do not have the backdrop of whether they were in compliance with federal standards and achieved good ratings, i.e., the intent and purpose of CRA. And what good is a study of banks/institutions that hesitated when you had a secondary market pushing for more, more, more??????

    One more problem — read the footnotes. You have foreclosure estimates used in several populous and tenuous counties. Might make a difference, eh?

  5. J-Wild says:

    Your assertion that the cause of the current financial crisis has to do with greed caused by CRA’s, a thirty year old federal program, is just false in both real and common sense terms.

    I understand you wanting to discredit the T&H study.

    Saying the Heritage Foundation study is out of date implies that you believe CRA loans made a drastic turn from 2005-2008. I don’t agree that is possible given the way an entrenched federal mandate typically works. And there just aren’t millions of poor people who were suddenly flushed with cash to buy homes.

    In order for your post to be true then it would mean that the US government is about to spend $700 billion dollars to fix the economy because banks and investment houses loaned too much money to poor people. Throw out the Heritage Foundation Study and T&H, that just doesn’t even make any sense on a basic fundamental level.

    The bonus pool for Lehman Brothers in 2007 was $9.5 billion dollars. More money than what the entire US Government gave in aid to Africa in 2007. Greed and unethical accounting practices (notice I didn’t say illegal) amongst the relatively few in this country who pulled and manipulated the leavers of capitalism deserves your scorn, not the poor.

    I agree with Cynthia Tucker, a columnist for the Baltimore Sun when she said:
    “..the credit crisis is an all-American disaster, a melting pot of greed, recklessness and myopia. Those all-too-human traits aren’t limited to any particular race or ethnic group.”

    I find it unfortunate that blaming the poor for this gains any traction with people.

    Appreciate the conversation. Back to my day job as well 🙂

  6. mmjdiary says:

    Whoa — no one blames the poor. Let’s not reduce ourselves to the usual emotion-filled ad hominems. The point is that there are perhaps better ways to help.

    My original commentary was that when you try to mandate social responsibility, you introduce unintended consequences. The unintended consequences were that there was money to be made through a government program set up with the best of intentions. Just the federal pre-emption of state maximum interest rates was part of the problem.

    You are forgetting the secondary market in your response — the bundling is the problem. We don’t know what’s in them — could be undervalued assets for all we know. But the easy availability of mortgages (and not just the CRA lenders in the study) made them plentiful. That plenty led to packaging and that packaging led to ratings and those ratings led to — and, yes, there could be billions of dollars (maybe $700 B) of effects from the mortgage market. Come back when you have the following:

    1. Mortgage figures from 2006 and 2007
    2. ALL figures
    3. Actual foreclosures
    4. Documentation on the areas that are now worse off — i.e., Cleveland and Baltimore???

    Bottom line? Back to Uncle Milton — we must proceed with caution in mandating social responsibility. We do not have to agree on everything to admit that there are consequences to mandatory SR even when done with the best of good intentions. Backfire is a nasty sort of thing.

    Funny that those who are not satisifed with companies doing good because it helps them are more than willing to mandate such good deeds, and the consequences to the markets be damned.

  7. mmjdiary says:

    Figures emerging now, as we sort through the Fannie mess, show that between 2004 and 2007 Fannie purchased $1 trillion in Alt-A mortgages.

  8. J-Wild says:

    As this thing unfolds it appears as though the problem is bigger than even Freddie and Fannie ($55 Trillion Credit Default Swap “shadow market”). Freddie and Fannie definitely had a hand in toxic mix, but scary as it is, they might end up being just bit players by the time all of this is brought out into the light.

    Your overall point of mandating social responsibility as it applies to CRA’s this wasn’t a social program. It was an incentive to get banks to loan money to undeserved communities at a much tighter regulated rate than the general mortgage markets were. Time and again those communities over 31 years had far fewer foreclosures and defaults on mortgage loans than the normal market.

    You talked about “tone” in your most recent post. Even Lehman CEO Fuld, under intense questioning from Republican Rep. John Mica of Florida, said Fannie and Freddie had little reason to do with Lehman’s demise.

    The government mandates social responsibility all the time. Taking care of the sick and the poor, arming and training a military for protection, and spending money on infrastructure are all things unable to be addressed by any one or single group of individuals. The American people mandate that our Government move with socially responsible things all the time. CRA’s being the least of our request.

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