An alternative to regulation of risk

Published 8:05 pm Friday, April 11, 2008

In a private home just outside of Munich, Germany, there might still be a photograph of me. In a scrapbook or a souvenir collection stowed in the attic, there I am, in the center of the small family who wanted their picture taken with a real cowboy. And, some years ago, in the streets of Winthrop they had mistaken me for one. They were so sure about me and so enthusiastic about taking the photograph that I didn’t have the heart to dissuade them.

That case of mistaken identity took place quite some time ago, but it was a memorable occasion for me. What city kid who grew up on movie westerns wouldn’t want someday to be mistaken, however improbably, for a real cowboy?

The desire to be mistaken for someone else fuels entire industries; certainly the movie business owes both its existence and continued prosperity to this. While making movies is a complex operation involving a lot of different talents and resources, it simply could not exist without a constantly refreshed supply of people who are really good at pretending to be someone else — and an audience that enjoys watching them do it.

There is more to life than Hollywood, though, and more to the U.S. economy than the movie industry. And in the markets that support our economy and give it much of its efficiency, it is important that the participants have real identities, not pretend or mistaken ones. Mistaken identities in the financial world always spell trouble.

Real identity is an important idea for us to hold as we move toward changing the economic environment that brought us to the fine mess we are in. The other idea that we need to keep in mind is “informed consent.” While this concept most often comes up in a medical context — did the patient understand the risks of this operation? — it is time to move it into the broader economy.

The reason why these two ideas are important is that, combined, they offer a way to fix the financial markets without regulating the life out of them. They are especially valuable at a time when calls for tighter regulations on financial markets are getting louder.

The mistaken identity issue should be dealt with immediately. A bank, for example, should be a bank. It should take people’s deposits, provide transactional services and make good loans. It should not be moonlighting as a wildcat oil driller. If there is a chance that it could be mistaken for a casino, because of its high-risk activities, then it should be identified as a casino.

The ability to take people’s deposits — to be a bank — then should be dependent on the risk level of all of its enterprises and commitments, not just the quality of its loan portfolio or the stability of is deposit base. That is not to say that you cannot engage in high-risk activities. You simply cannot do that and still call yourself a bank. It’s an identity issue.

Reducing the potential for mistaken identity will help depositors, borrowers and lenders understand what kind of organization they are dealing with and what kind of risk is involved.

Applying the idea of informed consent would help, too. Much of the inertia that has stalled our efforts to sort out the subprime mortgage mess is due to our very different assumptions about the nature of the mortgage transactions themselves. Were they cases of predatory lenders luring and hustling home buyers who didn’t understand what they were getting into? Or were they situations where the homeowners knew exactly what they were doing and are now trying to avoid responsibility? You can find ardent supporters of each version.

When it comes to motives and who knew what, we will probably never know for sure. But we can probably eliminate most doubt about future mortgage transactions by adopting a reasonable informed-consent procedure.

Most real estate, legal and loan documents are, at a minimum, not easy reads. Most of us feel a strong temptation to skip over parts, or simply ask, “Where do I sign?”

For higher risk mortgage transactions, a pile of signed, small print documents should not qualify as informed consent. Instead all mortgages destined to be resold to investors would be required to include a video recording of the closing, including the buyers’ answers to a scripted list of questions provided by, say, Fannie Mae which provides the gateway to the secondary market.

We cannot regulate ourselves into a risk-free economy. But if we take action on the identity and informed-consent issue, we can at least ensure that we don’t make the same mistakes again. Let the subprime mess take its place in history — and stay there.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.