Aleablog is worth visiting. Several times a day. Today they point out a study (The Future of Securitization by Günter Franke and Jan Pieter Krahnen) linking incentives, particularly bonuses, to the collapse in securitized products. There’s a danger here of linking this sort of study to initiatives to reduce senior manager pay, or rattle sabers on income inequality. As if the mere quantity of compensation, rather than its structure was the guilty feature here. Of course, we have no doubt that the casual reader with the proper political bent will depart with that take-away. That is, however, naive, and those dangers aside, we think this one of the smartest works on the issue in a long while. (If somewhat belated. Not to boast, but I’ll just boast that some of us were onto this issue over a year ago- forgive the shameless self-citations). But, then, we love anything with Goethe’s name attached. Key passage from the abstract to note:
Our policy conclusions emphasize crisis prevention rather than crisis management, and the objective is to restore a “comprehensive incentive alignment”. The toe-hold for strengthening regulation is surprisingly small. First, we emphasize the importance of equity piece retention for the long-term quality of the underlying asset pool. As a consequence, equity piece allocation needs to be publicly known, alleviating market pricing. Second, on a micro level, accountability of managers can be improved by compensation packages aiming at long term incentives, and penalizing policies with destabilizing effects on financial markets. Third, on a macro level, increased transparency relating to effective risk transfer, risk-related management compensation, and credible measurement of rating performance stabilizes the valuation of financial assets and, hence, improves the solvency of financial intermediaries. Fourth, financial intermediaries, whose risk is opaque, may be subjected to higher capital requirements.
(Much) More after the jump.
Securitization: Not Guilty [Alea]
Kierkegaard, Scientologists, Private Equity [Going Private]
Liquid Reflections [Going Private]
My own view on human nature can be summarized about thus:
Man is basically lazy. Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior). Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.
Tempting as it is for some populists (even rational populists) to decry “deregulation” and “free markets” as the cause of the current morass, I think this short-sighted. The reality is that nothing at all like a free market existed in the mortgage industry. (Where mortgage industry is defined from origination up to securitization^3).
At the origination level: Those writing loans were at least partially unlikely to be the parties holding the loans. A massive industry in mortgage origination (nothing but front-end paper pushing) sprung up from basically nowhere in the last 10 years. These firms, the de facto marketing and sales organizations for lenders, were incentivized to pump out loans in size and push them up the ladder. Few, if any, repercussions were present for failed loans. To the extent that there were repercussions for loans that eventually went bad, they were long-term. The loan actually had to go bad before, for instance, commissions would be clawed back. In this light the widespread growth in mechanisms to forestall inevitable default as long as possible (balloon mortgages, ARMs, etc.) were highly predictable. One might also surmise that a graph of the lifetime of mortgage origination firms would have a serious spike right before the average balloon payment maturity date.
At the aggregation level: Fannie and Freddie along with other players like IndyMac were anything but rational market actors. Between subsidies, incentive misalignment and sociopolitical pressures to “do more” their underwriting standards, credit standards, oversight and culture was deformed into mortgage creation factories. Why no one suspected anything when these firms were bragging about their great successes in including in great numbers customers who did not previously meet their underwriting standards says more about the political environment than the free market. Anyone who believes the eventual (and inevitable) collapse of this market inefficiency has anything to do with the evils of capitalism just hasn’t been paying attention. To be clear, no administration, Republican or Democratic since Carter is free of responsibility here. I would tend to point a few more fingers at certain administrations that sponsored legislation that had serious and obvious anti-market effects, but my political leanings are decidedly laissez-faire, so salt them to taste.
At the securitization level: The promiscuous rating agencies being prone to slop AAA on about anything, the actual risk of MBS instruments was poorly represented. Add to this that most MBS instruments were marketed with statistical summaries of the underlying mortgage pools, and you have risk that is under-priced on its face as well as under-priced given the lack of information available to the ultimate holder. (Try and value a slice of a CDO that has a MBS portfolio with wide manager discretion. Not only are the MBS’ opaque, but you never know one minute to the next which MBS’ the manager is holding).
The system was rigged to pour cheap leverage into assets that were badly under-priced for their risk. Literally trillions of dollars of badly mispriced risk was sold to various parties over the last several years. This being not just the de facto goal of the system, but the stated political goal of the system, and the fact that it sustained such a significant disequilibrium as long as it did, the housing bubble should be rated as one of the most significant, run away successes of the last 80 years in the area of economic central planning. Excellent work, team!
EP,
Wasn’t it always obvious and apparent (despite the lack of media coverage) that much of the predatory lending was due in part to loan officers being paid on a sales commission structure and not footing any risk themselves? I realize this hasn’t exactly been well-publicized (despite its overt existence)… but why are we acting like someone reaching this basic and altogether obvious conclusion is groundbreaking? They deserve kudos for posting something that’s been largely ignored… but little more.
“some of the universal tenants about mankind” ???
right quartile mate….
Way too long, definitely didn’t read
“Wasn’t it always obvious and apparent (despite the lack of media coverage) that much of the predatory lending was due in part to loan officers being paid on a sales commission structure and not footing any risk themselves?”
I think it was, but I don’t know what that’s worth.
“but why are we acting like someone reaching this basic and altogether obvious conclusion is groundbreaking? They deserve kudos for posting something that’s been largely ignored… but little more.”
I did point out in the piece that I thought this was somewhat belated. Still, the study looks to have been a lot of work. Perhaps they started on it a year ago. Who knows?
All that ranting and nothing on Moodys and S&P and their crappy government allowed monopoly. That is government regulation at its best.
In hindsight, less kudos should go to these researchers for determining the obvious, and more towards ep’s conclusions including:
“Why no one suspected anything … says more about the political environment than the free market”
“Anyone who believes the eventual (and inevitable) collapse of this market inefficiency has anything to do with the evils of capitalism just hasn’t been paying attention.”
“To be clear, no administration, Republican or Democratic since Carter is free of responsibility here.”
and especially:
“This being not just the de facto goal of the system, but the stated political goal of the system, and the fact that it sustained such a significant disequilibrium as long as it did, the housing bubble should be rated as one of the most significant, run away successes of the last 80 years in the area of economic central planning.”
I wish these sentiments could be published and disseminated on a far greater scale — to educate the booboise masses who knee-jerkingly pin the current situation on the greed of Wall Street fat cats without so much as a thought so the real why’s and how’s of this occurence.
As much respect as I have for DB, I wish a publication with a national (and populist) readership would carry this.
Too long. Didn’t read.
Bess – please get EP in line.
Want ‘em short and sweet, ok?
Oh…. and interesting. Not like we didn’t know this already.
http://faustasblog.com/?p=6908#comment-6631
#6: “I wish a publication with a national (and populist) readership would carry this.”
But why? I don’t see what good it does to show all those populists how Wall Street and the mortgage industry subverted their good intentions. It doesn’t do Wall Street or free market ideology any good. It is further proof that our elected officials are incompetent, but who needs more proof of that?
EP is right to focus on incentives–but focusing on misalignment of incentives in the past is only partially useful. This same kind of analysis needs to be applied to legislators/regulators themselves. We get what we pay for. If we want effective, unbiased governance, we need to pay legislators more, increase terms lengths and severely restrict private sector employment for former elected officials. But who’s going to advocate giving politicians a raise?
This was all Bill Clinton fault, and those liberals who hate freedom, and the troops.
Too long. Didn’t read.
Bess – please get EP in line.
Want ‘em short and sweet, ok?
Oh…. and interesting. Not like we didn’t know this already.
If you boil it down, the media has let the American people down big time. The Blogosphere is the new media and they are doing their best but there is nothing like the national news to bring something to the attention of the American people and they just didn’t do it.
I mean mom and dad are working their three jobs each and selling on ebay and day trading and managing a household and a family. Leaves little time for anyone to really ever relax no less get all the news. And, just because someone works on Wall Street doesn’t make them any different form Jane and Joe Six pack. You spend what you earn and save little. At the end of the month, no matter who you are, if the bills are all paid and there is a little money left you consider yourself fortunate.
Re #12. (I just got this from “the average American people” regarding your comment …)
Too long, didn’t read.
(Is American Idle on yet?)
@9: But it does Wall Street and the free market ideology plenty of good.
Whereas we’re all cognizant that the blame here belongs to a whole host of guilty parties, the mainstream press as well as the non-technical “Main Streeters” (as expressed in any “Comments” section of a WSJ/NYT article, as well as the fact that the bailout was originally stymied after legislator inboxes were flooded with angry emails), seemingly all the blame for this is being pinned on Wall Street and unfettered capitalism.
I fear that without an honest, Main Street (I hate that term) oriented assessment of what caused this, the current widely held belief that taxpayers are paying the price for the supposed greed of WS banks will prevail — never quite fixing the underlying problem of risk/reward misalignment, but more importantly, threatening the Street’s image when it may need it (i.e. the first House vote on the bailout).
@ EP, 9, 12, 14, etc
The only way the real story will ever get any sort of distribtion is if a lone ‘main street’ outlet or ‘journalist’ pulls his/her/their head out of his/her/their ass and realizes it has the potential to make their career.
All we have to do is convince them of it. Remember, its all about incentives…
Re #6. Aren’t you assuming that “main street” is capable of understanding the issue? Wouldn’t THAT require comprehending some subtleties? The average peasant hasn’t got the time or the brains. Years ago, when “da unions” controlled the peasant’s brain, at least they were pointed in the correct direction when the battle started. Now, with fascist-patriot-radio screaming in their ears, the peasants are as likely to turn on each other than “da bosses”.
The best hope for the US is that it will become like China. All the average peasant wants in life is to be told their “great nation” is “da greatest”. (Queue eagle, Queue patriotic music, Queue flags …) They also like it when their imaginary-friend happens to love their country “the best” too.
Help Jesus win. Vote Republican!!
To equate the poor execution of the laws regulating the mortgage and banking industries to central planning is quite a stretch. And if you say the laws were in need of revision, then those who write the laws (mostly industry lobbyists) are also responsible for the fiasco. Crony capitalism is not the same as central planning.
Gee #16. Why make this discussion political?
You know how the chartists just love to say “this stock is broken”…well
Cliff notes: people got too greedy
Isn’t an implication of the first policy prescription that securitization, as actually designed and utilized up to now, was part of the problem because it created opaque values that negatively affected the liquidity of the instruments? My understanding is that one of the key issues with mortgage CDOs is how complicated it is to get an actual value of their expected future value – which is why the market in them completely broke down when a problem developed in the underlying asset pool.
don’t let the haters win, EP!
“To equate the poor execution of the laws regulating the mortgage and banking industries to central planning is quite a stretch. And if you say the laws were in need of revision, then those who write the laws (mostly industry lobbyists) are also responsible for the fiasco. Crony capitalism is not the same as central planning.”
I really don’t see how. You had a very strong, politically mandated push to underprice mortgage risk. You had active pressure applied to quasi-governmental entities, filled with what amounts to political appointees, to push down mortgage rates. Someone decided that the “American Dream of Home Ownership” was a priority, and that we were going to lower the underwriting standards until we got more citizens into mortgages. Fannie and Freddie has specific benchmarks to clear. That’s not a lot different than telling Production District #15 that they will be producing X tons of steel next month. That’s not crony capitalism. There’s nothing capitalist about it. Mortgages stopped being priced by the actual market years ago.
This is totally divorced from scandals like IndyMac, where even attenuated underwriting standards were routinely overridden by senior management. THAT, is under-enforcement, but its only part of the problem and in any event it is driven by the political mandate to “get people into home ownership.”
+1 more pls
“Someone decided that the “American Dream of Home Ownership” was a priority, and that we were going to lower the underwriting standards until we got more citizens into mortgages.”
The key to this puzzle is to tell us who that someone is. I can offer you several quotes from one very powerful individual in the executive branch of the government who made compatible statements in 2002 and 2004.
Also, there were early warnings about the lax underwriting standards from powerful people inside the Fed (Gramlich) and from the Treasury Dept. (Bair) back in 2001.
This should be interesting reading:
http://www.nytimes.com/2007/12/18/business/18subprime.html?_r=1&oref=slogin
The important thing is that these “central planners” had a lot of authority to control the situation and chose not to exert it, no matter what their apparent motivation was. I call that a failure of “central planners” in favor of crony capitalism.
“The key to this puzzle is to tell us who that someone is. I can offer you several quotes from one very powerful individual in the executive branch of the government who made compatible statements in 2002 and 2004.”
You aren’t looking far enough back, frankly. You can go back much farther to begin to discover this stuff. Your focus on these years has a… whiff of politics to it.
Hot Damn… EP has come out to play today…
~SEG
getting popcorn and pouring a drink…
Except the asset bubble occurred in this decade, and the legislation that accelerated the instruments that failed is likewise recent. Blaming Carter (or Reagan, or Clinton) for Greenspan’s grasping desire to protect his legacy and the CFMA is worse than glib.
“Except the asset bubble occurred in this decade, and the legislation that accelerated the instruments that failed is likewise recent.”
I think you haven’t carefully examined the history of Fannie and Freddie. That’s 1990s vintage stupidity.
@ 28
Just because the bubble “occurred” in this decade does not mean its foundations did; your statement is the epitome of a non sequitor (although 99% of statements regarding the blame for this predicament are, too, sigh…)
@29
EP, there’s a lot more to this story than Fannie and Freddie. The apologists for Greenspan and his political party use 2 things as talking points, all already debunked elsewhere: CRA, and GSEs (Fannie and Freddie). Though you covertly are referring to CRA above, at least you do mention specifically the GSEs.
The bottom line is that it’s the responsibility of good government to avoid train wrecks like the one we just experienced in the last housing bubble. When prominent people within the executive branch of the government were ignored, after raising the warning flags and proposing good solutions, there’s no excuse. They were ignored because their proposed interventions didn’t conform to the ideology of the people at the top.
Think about crisis management. You may have got into a crisis by no fault of your own. You work with the tools you have to manage the crisis, and make new tools if need be. When Apollo 13 was about to be lost in space the flight director was not concerned about why the oxygen tank exploded. His mission was suddenly changed to bringing back the crew alive. And he did.
But when your policy positions are driven by fierce unrelenting ideology, it’s so easy to miss the fact that a crisis is occurring, and easy to ignore the right measures to correct it.
Nice chatting with you…
“The bottom line is that it’s the responsibility of good government to avoid train wrecks like the one we just experienced in the last housing bubble. When prominent people within the executive branch of the government were ignored, after raising the warning flags and proposing good solutions, there’s no excuse. They were ignored because their proposed interventions didn’t conform to the ideology of the people at the top.”
You and I simply disagree on the role of “good government.” To you, it seems, that is to ‘avoid train wrecks like the one we just experienced.’ I think that was mostly caused by government, but here we probably just have to agree to disagree.
(Though I will note that you contradict yourself, saying that government was responsible with fixing it, then observing that government blew it, and then observing that it was the people up at the top (the highest levels of government) that mucked it up, you have now put us in the position of electing omniscient supreme leaders to avoid the next crisis. Or you are going to have to claim that administrator X (fill in your favorite candidate) would have gotten it right and saved us all. I suppose our departure is here. I don’t think administrator X exists.
I will place my bets on some other horse than a few administrators who are supposed to be incorruptible, and all knowing, keeping the bureaucracy in check, thanks.
@32
You don’t have to be omniscient to be good at what you do (or supposed to be doing). I prefer perspicacity, something that humans can possess.
Regarding the role of government, there are a lot of people at the top who are like Grover Norquist, well at least they owe their political career to him. His famous quote defines his ideology and is:
“I don’t want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub.”
I’m sure Grover’s followers are a little distraught right now, dazed and confused, offering no visible and meaningful leadership in this crisis. But them, and everyone else, will pay for this folly.
the responsibility of good governors, for lack of a better word, is to represent the people who elected them to the best of their ability. Even if heir constituents represent a view to which they are diametrically opposed.
Like some stocks, somehow the system is “broken” again for lack of a better word. No matter who you elect as president (although for a true balance of power it is always better to have the representative majority different from the presidential winner and not to allow legislation from the bench) if you don’t fix the festering sores then that president will be nothing more than a figurehead.
(I love tennis matches where the ball is hammered back and forth, people adjusting in motion, or not… ;-) )
~SEG
Diablo, your comments are some of the most insightful I’ve read on DB lately.
I’m no government apologist, and indeed, having grown up in a quasi socialist nation, know only too well the dangers of an overarching government.
However, let’s be clear that the fall-out from the lax standards are merely a part of the problem (the majority of home loans are not sub-prime).
The sub-prime defaults may have set a spiral in motion which has been compounded by the fact that:
a) there are major valuation issues and faulty risk assessment with MBS
b) financial sector leverage levels compounded even the slightest downturn several times over.
Now these two issues are not affected by government mandates. They are the result of fairly liberal regulation, but that regulation was pushed through by industry consensus, so presumably the private sector knew what it was doing.
Long enough to be interesting. Read.
“Man is basically lazy. Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior). Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.”
Who or what would create and refine these structures if not lazy men?