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I know this is a lot to ask, but does anyone out there feel like doing a rewrite on this paper so I can do my rewrite?
-- DanKarmel - 22 Jun 2010 | | | Hot Potato | |
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< | The critical element uniting all the players, whether they believed that real estate was never going to die, or whether they were prepared to make billions pushing it over, was that no one bore the risks for their bad investments. Mortgage lenders originated the loans and would generally sell them in huge pools to investors within weeks, sometimes days. The loans were then passed along and cut up through various entities, all the way up to the government-sponsored Fannie Mae and Freddie Mac. At both the front and the back, the ones usually left holding the bag were the original borrowers and the government-sponsored corporations. Even the major credit rating agencies, like Moody’s and Standard and Poor’s, the entities most in need of a proper perspective on risk, were paid by the banks issuing the securities they were rating, and similarly created risks for which they were in no way accountable. It would be as if “Hollywood studios paid movie critics to review their would-be blockbusters." So to answer the question of why some of the best minds in finance didn't figure out that they were building a house of cards - they had no incentive to. | >
> | The critical element uniting all the players, whether they believed that real estate was never going to die, or whether they were prepared to make billions pushing it over, was that no one bore the risks for their bad investments. Mortgage lenders originated the loans and would generally sell them in huge pools to investors within weeks, sometimes days. The loans were then passed along and cut up through various entities, all the way up to the government-sponsored Fannie Mae and Freddie Mac. At both the front and the back, the ones usually left holding the bag were the original borrowers and the government-sponsored corporations.
I'm no housing-bubble-2008-collapse-expert, but this seems to be a trivial and probably incorrect recollection of what exactly went on and why everyone was tied together. First, this paragraph seems to suggest something contrary to your statement “no one bore the risks.” Indeed, if the catalyst for the crisis was the vaccuum in the demand for housing created by changing population demographics (as I believe), then the reason for the catastrophe was that the housing industry connected itself to everything. To borrow Matt Taibbi's metaphor, the housing market seemed to have its tentacles on everything. Indeed, the problem is not that “nobody bore the risks” but rather that everyone bore the risks, thanks to junk mortgages tied to junk CDOs tied to insurance policies tied to just about everything. Therein lies the problem—too many people bore opaque risks they didn't understand and the only people who did understand them shrugged them off onto other people.
Even the major credit rating agencies, like Moody’s and Standard and Poor’s, the entities most in need of a proper perspective on risk, were paid by the banks issuing the securities they were rating, and similarly created risks for which they were in no way accountable. It would be as if “Hollywood studios paid movie critics to review their would-be blockbusters." So to answer the question of why some of the best minds in finance didn't figure out that they were building a house of cards - they had no incentive to.
This is one way of looking at it. The other equally plausible way of seeing it is sheer ignorance. Or smart people do stupid things. Or maybe they knew exactly what was going on and just thought they could get out in time and missed the last boat. I think what you mention is certainly a problem—but it does not answer the question--at least not sufficiently here. | | | After The Sale | | | For one, we call the borrower a “homeowner.” Of course, there’s a difference between that and owning your home free and clear. Yet the mortgage industry wants you to be a homeowner right away, regardless of what sticks you get in that bundle - because why would a homeowner walk away from the home he owns? Additionally, the deal itself is being burdened with all sorts of extraneous notions. In The Path of the Law, Holmes wrote that “[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it and nothing else.” When you take a mortgage, you borrow money in exchange for a promise to either pay it back or forfeit the security. Although borrowers are aware that they were making an exchange, as opposed to getting a gift, they are mistaken as to the exact nature of that exchange. If they understand that the mortgage crisis is a result of a misalignment of incentives and risk, then perhaps they can look at their own contracts, which are allocations of risk, and more accurately understand what part of that risk they bargained for, if any. | |
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> | I'm sort of confused about the conclusion here. Maybe the solution is just to tell people walk away. I think there is a valuable insight here—if we recast the situation to the “homeowner” as one of a failed bet, we might be able to convince people to walk away from failed mortgages. Obviously this cannot happen for a number of political and psychological reasons. But the problem isn't a misalignment of incentives and risk, it is a problem of information asymmetry. In the transaction chain that you have identified, mainly, homeowner → lender → bank A → big bank B → AIG → other banks, there seems to be one or two groups that are able to peek at the cards of all the other groups. If all of the groups had access to the same information, many of these transactions never occur and homeowners, when their bets fail, simply walk away. (This information assymetry is not really unique to the mortgage crisis but occurs in the stock market too. )
One thing I have thought about recently is that if the problem is information assymetry then a possible solution is not less opaqueness but more opaqueness. We seem to think that the SEC, FTC, etc. are doing their jobs. We seem to think that the stock market is regulated. We seem to think that there is no insider trading. But I think that we might be wrong, especially on the insider trading. And, again, the problem isn't the insider trading itself, but that there is a select group of people who can get away with it at higher frequencies than other groups. Thus, the problem is the whole incestuous regulatory system itself. If we just did away with all of it, allowed insider trading and opaqueness, maybe people would do their due diligence before taking on risk. Sure, mortgage rates are higher and loans become more expensive in order to insulate against unknown risk. But, the “open information” that accompanies things like mandatory financial statements and whatnot seems to do more harm than good. We ignore the risks of shoddy accounting because we thing regulation is competent. | | | Hi Dan, I'm just going to read back a bare-bone outline of your essay. I'm not even sure what it's about, so maybe if I give you a simple reiteration of my understanding, you can see if you expressed yourself clearly. |
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