Monthly Archives: March 2011

The Unanticipated Consequences of MERS

By William K. Black

(cross-posted with

One of the defining motifs of theoclassical economics textbooks is the provision of examples of the unintended consequences of government action. Those consequences are invariably negative. The narrative is the government intended to achieve some goal, e.g., help the poor, and ended up harming the poor. Four counter narratives virtually never appear in these tracts. Theoclassical economists rarely mention: 1. Any governmental program that succeeds in its aims 2. Any governmental program that has unanticipated, positive consequences 3. Any private action that has negative unanticipated consequences 4. Any private action that has negative, intended consequences
A fifth counter narrative sometimes appears in theoclassical accounts – governmental actions that are intended to be harmful by the private parties that corruptly convince public sector actors to aid the private parties at the expense of the public interest. The fifth example reflects poorly on both the public and private sector actors and suggests that the private sector is a source of corruption of the public sector – which fits poorly with theoclassical dogma.
This column focuses on MERS as an example of the first and third types of counter narrative. It will be the first in a series of columns about MERS. A conservative, but not theoclassical economist, Hernando de Soto, is famous for his work on private property. I highly recommend his book: The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. De Soto’s primary point is that private ownership of real property allows even poorer people to mobilize their limited wealth by pledging the real estate as security for loans. The individuals can use those loans as a source of capital to become entrepreneurs. De Soto uses the United States as an exemplar of his thesis, explaining that the colonies that become the U.S. began a system of public recordation of land titles and a system of surveying land. The developing U.S. made these systems a major priority. De Soto argues that these public sector programs were spectacularly successful and helped produce America’s economic success by encouraging entrepreneurial activity.

These two successful government programs (public recordation of land titles and transfers and public land surveys) achieved their intended goals. They made it far easier to pledge real property, which made real property more valuable. Public recordation greatly reduced the risk of fraudulent pledges. Reducing the risk of fraudulent pledges makes lenders more willing to lend and reduces the interest rates on secured lending. Reduced interest rates mean a lower “hurdle” rate for investment, which means that more productive investments will occur and economic growth will increase.

Public recordation in the U.S. became even more effective in spurring growth and efficiency with the development of Article 9 of the Uniform Commercial Code (UCC). Article 9 set out to make it far easier for lenders to access public records of liens by dramatically increasing the degree of uniformity in how and where such records would be kept. Article 9 was not only a governmental program that achieved its aim – it was the brainchild of an academic (Yale Law School’s Professor Grant Gilmore). Article 9 further reduced the risk of fraudulent pledges and greatly increased efficiency. Business, particularly lenders, strongly supported its adoption.

MERS (Mortgage Electronic Registration Systems) sought to privatize key aspects of the public title system. The primary purpose was to avoid recordation fees when interests in real property were assigned or transferred. MERS’ founders read like a who’s who of the entities who caused the recent financial crisis, so some scholars view its creation as an example of a private sector action intended to harm the public. This column assumes that MERS’ harms were, originally, unintended. It focuses on the insanity – from the standpoint of honest lenders and investors – of MERS’ devastation of a public system of recordation that had served business, particularly lenders and investors, brilliantly.

MERS’ problems are legion, but they are also inherent in its structure. This column addresses only one aspect of its “agency” problem. MERS is set up in a bizarre fashion designed to minimize costs. It has only a trivial number of real employees. It has no ability to check its members’ initial or continuing quality or integrity. MERS appoints its members’ personnel as MERS officers and exercises no meaningful oversight over their actions.

As I have explained in prior articles, MERS’ members have endemic, severe problems with mortgage documentation. They originated, purchased, or agreed to service loans and collateralized debt obligations (CDOs) without the underlying mortgage note. Fraud begets fraud. The exceptional incidence of underlying mortgage origination fraud led to widespread failure to prepare and maintain proper documentation – and that was before the mortgage originators failed. When the mortgage originators failed, as they did by the hundreds, mortgage documents were frequently thrown away. Mortgage documentation became particularly defective because originators could sell mortgages without the purchaser even checking whether the seller was delivering the original note.

The secondary market in nonprime mortgages operated under the financial version of “don’t ask; don’t tell.” The incidence of fraud and defective documentation in nonprime loans was so large that the purchaser faced an inescapable dilemma. If it did competent underwriting it would detect widespread fraud and missing notes and document that it knew that the nonprime loan portfolio it was purchasing (and then reselling them as the collateral for CDOs) was fraudulent. Documenting that one is selling CDOs one knows to be backed by fraudulent loans that often lacked the underlying note is an excellent strategy for going to prison and being sued by every CDO purchaser. The alternative was not to do any meaningful underwriting when purchasing nonprime loans. The no meaningful underwriting alternative, however, maximized the already perverse incentives to originate and sell fraudulent loans lacking essential documentation.

MERS’ members, therefore, had overwhelming incentives to engage in foreclosure fraud. The loans they were seeking to foreclose on often lacked essential documentation and were induced by defrauding the borrower. They had no legal right to foreclose, but that result was unacceptable to the senior officers controlling the loan servicers. They insisted on results, and did not monitor compliance with the law. The result was tens of thousands of felonies – monthly – by some of the largest financial institutions in the world. Filing false affidavits became business as usual. No one senior in the Justice Department or administration appears to be seriously upset about this. These felonies were committed by, or at the direction of, MERS “officers” – and MERS does not appear to be seriously upset about fraudulently foreclosing on the homes of tens of thousands of Americans. I study fraud by elites, and even I am stunned by the frequency and nature of the frauds and felonies and the lack of prosecutions and the overall blasé attitude by CEOs to the fraud and felonies.

Why We Are Only Fanning the Flames of the Crisis

By Erik Dean

A Reuters article Monday announced that a recent National Association for Business Economics (NABE) survey of 47 economists found that “excessive federal indebtedness” and state and local government debt constitute panelists’ first and second greatest concerns for the economy.  Without access to the full report, it’s difficult to say whether the article accurately reflects the results of the survey, but the public summary and previous NABE reports are at least suggestive. 
The tax cut extension ultimately effected in last December’s Obama-GOP deal, for instance, was ostensibly prioritized over deficit reduction by NABE economists last August.  The deal’s contribution to this year’s growth is expected to be sizeable, according to the February survey.  Given that the deal’s budgetary effects amount to nearly $900B in the red, it’s difficult not to see the majority position of the NABE panelists as implicitly predicated on certain distributional policies: government deficits and debt are only a problem once favorable tax policy for the wealthy is a done deal.
In any case, the article presents an opportune moment to discuss the fallacious argument that budget deficits imperil the solvency of the federal government (see also here and here for more thorough, and adept, discussions).  This line of reasoning is dangerous so far as it promotes, or justifies, a neglectful macroeconomic policy at the federal level, but it’s made all the more dangerous in its consequences for the very real fiscal crises in which our state and local governments currently find themselves.

The relationship of the federal government to state and local governments is similar to the former’s relationship to households in that the federal government is the issuer of the currency of which states, counties, cities, and households are users.  As users of the currency, state and local governments, just like households, cannot run budget deficits without risking credit downgrades and insolvency.  Recessions typically diminish revenues for these users of the currency at the very time that their expenditures are most needed.
Readers of this blog will be familiar with the potential, and the need, for the federal government, by virtue of its position as issuer of the currency, to promote employment, output, income, and private expenditure through public expenditure.  Households are reliant on this counter-cyclical fiscal policy to mitigate the destructive effects of economic downturns—particularly unemployment and the suffering it causes.
Households, however, are also affected by the policies of state and local governments.  We rely on state and local governments for many of the services that facilitate not only a decent life but also the future prosperity of the nation: health, security, education, employment, and a social safety net to ameliorate the vagaries of the market economy.  We also surrender the revenues by which these services are funded. 
The problem lies in the dynamic relationships between non-issuer households, non-issuer governments, and the issuer government.  In short, because state and local governments are financially constrained, their budgets tend to be pro-cyclical—expanding services and lowering taxes in booms, cutting services and raising taxes in recessions—, precisely the opposite of what households need from government.
As Prof. Wray has explained on this blog, as users of a currency they don’t issue, state and local governments, like households, must finance their spending.  Revenues can come from bond sales, intergovernmental transfers, charges on services (e.g. hospitals, universities), or taxes, but ultimately the money for the government services we rely on must come from somewhere. 
During a recession, however, these revenues typically decline and the budget crises we’re seeing today result.  Let’s consider a few options state and local governments have in this situation, and their social and economic desirability: tax increases, where possible, are not only politically unpalatable, but socially undesirable as well.  Averaged across the country, middle and low-income households pay roughly twice the state and local taxes of upper-income households.  Revenues through regressive taxation are thus likely to disproportionately burden the lower and middle classes.  It may be added that it is simply bad economics to further tax spending in a time of high unemployment and depressed spending. 
Perhaps, then, the problem can be solved in terms of the services these governments provide.  Increases, for instance, in tuition at state colleges are a plausible means of lightening the load on state coffers, and states and their university systems have generally had no problem going to this well in recent years.  But, it is doubtful that making higher education more expensive is a good long-run plan for any state; and it’s certainly not in line with January’s State of the Union address.  The same, of course, can and has been said of widespread layoffs of teachers. 
An NABE survey last August found that their economists turned to the reduction of public-sector employee benefits and pensions as well as programmatic cuts as favored solutions for state and local budget crises.  But this only advocates for the realization of the very problem we’re dealing with: the pro-cyclical nature of state and local budgets when households, and firms alike, need counter-cyclical action from government. 
Contributors to this blog have made more appropriate recommendations.  Wray argued some time ago for immediate relief of the fiscal crises of state and local governments.  Profs. Black and Carbone (here and here) have similarly argued for a revenue sharing program to offset the pro-cyclical nature of state and local budgets.  Wray continued by proposing the elimination of regressive taxation through federal incentives to states and public investment in infrastructure. 
It is worth noting that all of these are made possible by the federal government’s position as issuer of the currency; and all are made necessary by the positions of households and state and local governments as users of the currency.  It is in fact because the state and local governments on which we rely for many essential services are users of a currency they don’t issue that their budget constraints can actually exacerbate recessions.  Taking account of these facts, each of the recommendations from NEP bloggers avoids the myriad real, long-run harms of, e.g., making higher education unaffordable, laying off teachers and discouraging students from pursuing a career in teaching, cutting back vital government services, neglected much-needed infrastructure investment, and so on.
To the extent that it leads policy-makers at the federal level to cut spending, the fabricated budget crisis of the federal government can only fan the flames of the real fiscal crises of state and local governments and the long-run social and economic problems they create.  The well-known effects of sustained recessions, in terms of lost output and the myriad socials ills stemming from unemployment, are thus compounded by the efforts of state and local governments trying desperately to keep afloat: increased (regressive) taxes suppress spending and increase income inequality, social programs are cut just when they’re needed most, continued neglect of our declining public infrastructure jeopardizes our future prosperity, lay-offs and furloughs of public workers diminish essential services, employment, and spending
The Reuters article that sparked this post led with the federal, state, and local government debt and deficits as the “gravest threat[s] to the economy.”  It took care to note that these worries topped concern over high unemployment, which according to the NABE survey itself is expected to remain high.  The common run of facts suggests that the subordination of the real, and very much felt, crises of unemployment and state and local services to the federal deficit is absurd; economic theory merely confirms this.

Listen to L. Randall Wray on KUOW

Randall Wray appeared on KUOW‘s “The Conversation,” hosted by Ross Reynolds.  The topic: the largest contributors to the federal deficit–Medicare, Medicaid, Social Security, and Defense.  To listen click here.

William Black noted in IPA News Release

William Black was noted in a news release yesterday from the Institute for Public Accuracy.  The release quotes Black on the role of financial regulators in combating fraud and links to an MSNBC piece in which Black appeared with ‘Inside Job’ director Charles Ferguson.