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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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To find out about Ben, click here to read his bio.

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