Reason Magazine - Topics > Regulation

• Teaser Freezer Burn
  

  Given the amazingly complex world of high finance—full of derivatives, hedges, and tranches—Treasury Secretary Henry Paulson last week hit upon a stunningly simple plan to fix the nation's subprime mortgage mess: Lie. And don't just lie, but get everybody together and agree to lie, thereby making the lie become truth.

  The fiction Paulson and the major banks are promoting is that extending the low "teaser rates" initially offered to many subprime borrowers fundamentally will help them and—here is a big lie—transform them from bad loans to good.

  Put another way, if the problem of bad subprime mortgages was caused by delusion over lending risk, this latest solution enshrines delusion as the defining characteristic of the American banker—backed by a facile enabler in Uncle Sam and his trillions, of course.

  Financial risk analyst Chris Whalen calls Paulson's plan"appalling." Whalen's Institutional Risk Analytics zeroed in on the banks' unwillingness to acknowledge risk in their lending portfolios back in 2005. Now he sees the so-called "teaser freezer" plan as an attempt to put Humpty Dumpty back together again and build a floor underneath uncertainty in the financial sector. Except that he estimates around one-third of teaser borrowers will default anyway, a measure of just how dumb lenders are in handing out loans to people with bad credit.

  "It is probably in their best interest to walk away. They have no equity," Whalen says of the hapless borrowers.

  The possibility of their underwater borrowers actually taking a walk terrifies the banks, however. Banks would have no choice but to write down and make real phantom losses lurking just off their books. What to do? How about pretending that the loans aren't actually bad. How do you do that? Pretend that the borrowers can pay them back. How do you do that? Pretend the teaser rate is the real rate. Presto, problem solved.

  At this point, some adult would ideally step in and say, "no, that's fraud." But clearly Treasury is not that mature. And it appears the Fed has resigned itself to some form of greater idiocy coming out of Congress on the subprime front that maybe, just maybe, the teaser freezer can head off.

  However, the stubborn fact remains that banks will lose money on teaser rates. Regulators and investors both know this. Who exactly are we trying to fool? Besides inattentive voters.

  Meanwhile, by allowing big banks to keep their rot off the books, the potential exists for it to continue to spread. Whalen and other experts have wondered for months about losing the ability to price risk, or even recognize it given the complexity of the constructs floating around financial markets. The Paulson fix only exacerbates the problem by continuing to assert that real world constraints do not matter. And the stakes are already high.

  "We could lose a money center bank next year," Whalen warns.

  Should you duck your head out of Treasury's "let's pretend" camp for a second, one notices that there are major legal obstructions to rewriting millions of loan contracts by federal fiat. Contrary to the wish of some in Congress, mortgage lending is still largely an activity engaged in by two private entities, each of whom assume very specific obligations. This is not a federal program to be tweaked at the margins. Real estate lending contracts are a dozen pages long for a reason. And each contract is different yet just as legally binding, depending on a given state's law. That's right, state law.

  It is unclear how federal action to extend low-low teaser rates can square with state lending laws which may require an actual change in the underlying contract. Unless the idea is just to do this all informally, with a notification letter from lender to borrower and as long as federally chartered banks get approval from their federal regulators to pretend.

  After all, what is a little lie between friends?

  Contributing Editor Jeff Taylor is a writer in Charlotte, North Carolina.

• Scottish Smoking Ban Study Leads to Huge Drop in Journalistic Credibility
  

  Two months ago, a study reporting that the imposition of Scotland's smoking ban had been followed by a 17 percent drop in hospital admissions for heart attacks prompted credulous headlines like these:

  Smoking ban brings big cut in heart attacks in Scotland, study finds (The Guardian)

  Smoking ban 'reduces heart risk' (BBC News)

  Scottish smoking ban cuts heart attacks (The Telegraph)

  Scottish Smoking Ban Leads to Huge Drop in Heart Attacks (Der Spiegel)

  Now it turns out that the complete admissions data for the year following the ban show a drop less than half as big as the one claimed in the study and in all those news stories. And as Michael Blastland shows in a recent BBC News article, the 8 percent drop may simply be part of a long-term trend:

  Heart attacks have been falling steadily for some years now. The percentage falls in the three years before the ban were 5.1%, 4.7% and 5.7%. So the fall since is still bigger than the trend would lead us to expect, but bigger only by about three or four percentage points—an improvement, but retreating fast from the magnitude of 17.

  The latest release also makes clear that even an 8% fall in heart attacks is not unprecedented. There was another, larger drop between 1999 and 2000 of about 11%.

  This seems to demonstrate significant variability around the trend, suggesting that last year's 8% drop might even be the result of chance. It is conceivable, although perhaps unlikely, that the smoking ban had no effect at all. The figures could be a result of no more than the ordinary ups and downs of statistical variation from one year to the next.

  Reporters can't be expected to look at data that haven't been released yet. But the idea that a smoking ban could cause an immediate, dramatic drop in heart attacks, whether by reducing secondhand smoke exposure or by encouraging smokers to quit, is so scientifically implausible that journalists should be automatically skeptical. Random variation and/or continuation of pre-existing trends are much more likely explanations for a decrease in heart attack admissions that happens to follow the imposition of a smoking ban. In the absence of more evidence, including additional years of followup and data from other jurisdictions with smoking bans (most of which apparently have not seen the big changes found in the few places that anti-smoking activists like to cite), the breathless reports prompted by studies like this one are absurdly premature.

  [via The Rest of the Story]

• The Addict's Veto
  

  Annie Duke, who testified at a recent House Judiciary Committee hearing on Internet gambling, is not a typical poker player. A professional for 13 years, she is the biggest female money winner in the history of tournament poker.

  Gregory J. Hogan Jr. is not a typical poker player either. As his father, the pastor of the First Baptist Church in Barberton, Ohio, explained at a House Financial Services Committee hearing last summer, "Gregory Jr. is currently in prison for a robbery he committed to feed his online gambling addiction."

  While Annie Duke recognizes that most Americans who play poker do it for fun, not for a living, Pastor Hogan tends to overgeneralize from his son's equally extreme experience with the game, which involved losing hundreds of dollars a day while playing 12 hours at a time. Hogan demands an addict's veto over Internet gambling: Because his son robbed a bank, he thinks, no one should be allowed to play poker online.

  "I oppose any effort to legalize or even give credibility to Internet gambling," Hogan said. He called last year's passage of the Unlawful Inte