Incentive Systems: The Mortgage Industry

Incentive Systems: The Mortgage Industry

BLOGGER: BEN PIERSON

 

“People respond to incentives in predictable ways.”

 

This is the first rule I was ever taught during my high school economics class and remains one of the most powerful I’ve ever learned.  I’m reminded of this rule often, in all contexts.  And, this applies to the mortgage industry.

In some sense, a cornerstone of our society is that we are all role players.  In the industrial revolution we discovered the value of specialization.  Instead of one person making each whole shoe by themselves, one person would cut the leather, another would hit the same nail in each time, and yet another would sew the same spot each time…  We rely on predictability; we rely on people fulfilling their role.  It’s up to us to understand what each person’s role is and how each person is predictable.   

So what does this have to do with mortgages, you ask?

Mortgages provide a good example of how the incentive system got screwy. People acted rationally, oversight was negligible and consequences became severe.  Mortgage brokers were paid based off how many mortgages they originated (‘sold’).  It made zero difference to their payout if any – or all – of the mortgages end up defaulting in two or three years.  The future risk would be the bank’s problem since the mortgage broker has already gotten paid and the mortgage now belonged to the bank.  Banks didn’t want this risk either (they were conscious to some extent of the risk in the mortgages they were selling), so would take all of these mortgages and resell them to, say, an Investment Bank (eg Lehman, Merrill, etc), who would then package the mortgages up and resell them again (eg. Mortgage Backed Securities and CDOs).  The individuals working at the mortgage broker, bank, and investment bank all get paid off revenue.  They all get paid at the point of sale, with little exposure to the future risks.

So to sum this up, you have a system where the people working at almost every layer are exposed to vast reward with finite risk.  And we now have terms such as the NINJA Loan (No Income, No Job, No Assets… no problem!) with the corresponding mortgage malpractice that has now come to light. 

To give an example to better explain this, like many others, if I am driving at 4am, the only car on the road, I will likely drive fast.  What keeps me from going very fast was the risk of getting caught.  The mortgage system and those working in the field aren’t any different.

The calls for tighter restrictions and regulations on banks and hedge funds are, for the most part, erroneous as fairly comprehensive restrictions and regulations already exist.  The problem is there’s little to no enforcement and the enforcement which exists is painfully inadequate.  I’ve only been on Wall Street for 8 years, but since the beginning I remember people making fun of how woefully inadequate the S.E.C. is.  In addition to the S.E.C., the Ratings Agencies (Standard & Poor’s, Moody’s, Fitch, etc…) were supposed to help regulate companies as well.  So, you’d think there was an adequate system in place to keep problems like we are in right now from happening.  Right?  Wrong.

Most people who played a part in all this mess – Mortgage Brokers, Banks, Investment Banks, and Ratings Agencies – were really acting as we should anticipate the would given the incentive structure involved with them.  Failings must be placed in a large part on then regulatory bodies like the SEC and Ratings Agencies who were set up explicitly to be outside of the ‘incentive system’.  One must also then throw blame on the government – and rely on them to fix this – for it would seem the problem grew from the innate nature of the structure.

Should you want to read more on the rating agencies’ role, here are two comprehensive (very detailed) articles:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajs7BqG4_X8I

http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=ah839IWTLP9s

Certainly this is a very complicated issue which has touched us all in some way.

What do you think?

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Unprecedented is an Excuse

Unprecedented is an Excuse

BLOGGER: BEN PIERSON

“If you can get people to ask the wrong questions, you don’t have to worry about the answers” (Thomas Pynchon)

Everywhere in the media we hear: the housing crisis is unprecedented; the credit crisis is unprecedented; the economic downturn is unprecedented.

To briefly cover the basics:

As we all might guess, “unprecedented” means “without precedent”.

Precedent à something similar has occurred.

Unprecedented  à  no similar event has – ever – happened before.

This gross abuse of hyperbole frustrates me greatly for many reasons.  Yes, included in these reasons is that I move quickly into this emotional state… That being said, I’ve calmed down and for your sake whittled my complaints down to three.

1)  No, no no – these events are not unprecedented.

During the Great Depression unemployment peaked at over 20% and the stock market declined over 90%!  Maybe our (great) grandparents didn’t really walk to school in the snow, uphill both ways; they sure lived through some brutal stuff though.

If you want to argue ‘unprecedented during our life time’ at least, wrong once again.

Quick Quiz:  Who am I?  I had an unemployment rate over 10% and the US Government set up a bailout fund for failed banks.  As an extra tickler people had to cue up for hours just to get gas for their cars and they could only try to do this every 2^nd day.  Yup, I’m the late 1970s/early 1980s.  FYI for those who don’t remember, the bailout fund was the R.T.C. – Resolution Trust Corp – and was created to buy ‘toxic’ assets from all the failed Savings & Loan banks.  Even on Wheel of Fortune, R.T.C. covers half of T.A.R.P.

Look, clearly what we are going through now is horrible.  Very very horrible.  Unemployment is rising but we’re still not even to 8% (a ‘boom year’ during the Depression).  In November of 2008 the markets hit their lowest point at -47% for the Dow and -52% for the S&P.  If you think this is painful, for us to get down to the Great Depression move of -90% things would have to get really crazy.  Bear with me for a second:

From down 50% (our current record) to down 90% (Great Depression) would mean the stock market would have to drop another, drum roll, 80% from here.  I know that sounds absurd but if you start with $1, down 50% means you have 50 cents left.  To get to down 90% (10 cents left), that 50 cents must drop another 40 cents… which is another 80%.  Math stinks, eh?  Imagine having to endure another 80% after 2008??

So to summarize:  the economy stinks, but it’s ludicrous to call this unprecedented.

2)  We all like to think we’re special, our friends are special, and the times we live in are special. And it’s true!  Just like all snowflakes are different, so are we… and so is every snowflake before us, after us, and next to us.  The social psychology term for elevating ourselves/our peer groups is called grandiosity, but that’s probably best left to the psychologists of this site.  The consequence of this characteristic is we latch on to ‘unprecedented’ because that gives us that extra feeling of grandiose.  We love jumping on the labels best/worst ever.  For example the ludicrous headlines of “best superbowl ever”. Heck, that wasn’t even the best one of the last two years.  Snoozer for 3 quarters (great interception return at the end of the first half), excellent last quarter.  I think I’m especially bitter about this because I had Pittsburg giving 7 and the under (0/2, for those keeping score), but I stand by my feeling that this grandiosity applies to ‘unprecedented’ as well.

3)  If something’s unprecedented, then we couldn’t have prepared for it, and therefore we’re absolved of guilt for allowing this to happen. This epitomizes the great reason of why the more erudite – those using ‘unprecedented’ while conscious of problems 1 & 2 – often use this word (I believe).

There was recently an encouraging article headline on CNN, “Obama’s speeches teach English.”  I’ll give you a minute to let this refreshing change of pace seep in.  I say we give him one of our leftover thousand points of light.

But I digress.  Even Obama is guilty of abusing the word ‘unprecedented’, citing in a radio address how, “We begin this year and this administration in the midst of an unprecedented crisis that calls for unprecedented action” (italics are mine).  He promptly contradicts ‘unprecedented’ (no similar event EVER, remember) when he says, “Just this week, we saw more people file for unemployment than at any time in the last 26 years”.  Since we’re all still in the Obama honeymoon period I’ll momentarily let him define unprecedented as, ‘not having occurred in the last 26 years’.  Fair enough.

So Obama has painted a severe picture at every turn.  I’ll definitely agree the picture is very severe, but what he’s also setting up is a situation where he can take all of the credit for good developments and avoid any blame for the bad ones.  He did the best he could in an unprecedented situation, after all!

The former heads of Lehman, AIG, and other failed banks all called their companies’ events unprecedented as well.  Here they did so not for politicking (though we WILL elect just about anyone…) but because none of them wanted to take any blame in the matter.  We would have been fine, but the unprecedented events in the (insert Housing Market, Credit Market, etc) destroyed us.

You know what the odd part is?  In a manner of speaking, the bosses of these banks didn’t do anything wrong.  I’ll address this strange twist in my next entry on the golden rule of economics:  “People respond to incentives in predictable ways”.

So what are your thoughts?

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