Housing: An Unparalleled Success Story

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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!

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