Market Failure, Mortgage Style
In our prior post, I alluded to the failure of markets and mortgage origination. This requires additional discussion.
When discussing free markets versus regulation, one of the basic tenets of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise. Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results.
Case in point: Mortgage brokers and underwriters reckless lending to unqualified borrowers during the 2001- 06 housing boom. The immediate gains in compensation for all parties involved seemed to totally overwhelm the longer-term concerns of ensuring loans get repaid.
The repayment of principle should be the single most important concern to any firm that lends money. Once that became secondary, we were set up for our market failure.
Under normal circumstances, the fear of losses and eventual business failure operates within the marketplace to prevent businesses from doing anything too stupid. Lenders should have been self-interested enough to not recklessly lend money to people who couldn't repay it. However, that seems to not applied this time around. According to the Mortgage Lender implode-o-meter, 262 major US lending operations have gone belly up since late 2006.
The normal operations of the marketplace simply failed to work. Where markets fail to prevent recklessness, irresponsibility and behaviors that inflicts significant damage on the broader economy, some form of limited government preventative regulation is called for.
A great nation, even a mostly capatilistic one (with quadrennial socialism) such as ours is not obligated to allow these failures to cause unfettered and ongoing economic ruin. The alternative is what we have today: An environment where anything goes, no referees are on the field, and the current housing and credit crisis was allowed to develop the unfettered.
There is a balance between free-market competition, and limited government regulation where absolutely required. The Greenspan Fed 's ideological preference for the former, has led to a situation we are where we are all but guaranteed the latter.
>
UPDATE: June 13, 2008 1:32pm
Paul Krugman notes:
The late Milton Friedman agreed, calling for the abolition of the Food and Drug Administration. It was unnecessary, he argued: private companies would avoid taking risks with public health to safeguard their reputations and to avoid damaging class-action lawsuits. (Friedman, unlike almost every other conservative I can think of, viewed lawyers as the guardians of free-market capitalism.)
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Where are all those bottom calling, perma bulls now? They actually floated the idea that the Bear Stearns debacle was the end of this mess.
Buckle up fu**ers, we're headed to new lows!
Posted by: Donny | Jun 11, 2008 10:32:54 AM
BR,
I partially disagree. Fed manipulated low interest rate and too much artificially created liquidity was a major cause of all the speculative, malinvenstments in real estate. We have too much Gov't regulation to say we operate a free market.
Posted by: Phil | Jun 11, 2008 10:36:03 AM
Without getting into the “regulate or not-to-regulate” argument, I wonder how much political and social backlash would have come if regulators had stepped in and stopped lenders from lending to unqualified borrowers. Would it be similar to class warfare rhetoric we hear now that the borrowers are getting foreclosed on? I can’t help but think a few social activists would have tried and throw in a race angle as well if the government prevented these loans from being made.
I do not doubt that Greenspan’s ideology was main reason behind the lack of regulation; however, I can’t help but think regulators didn’t want to be perceived in some villainous way for not allowing lenders to bend practical lending standards in order to get low income and/or minorities into homes.
Wouldn’t that perception, in some way, encourage lax regulation?
Posted by: Zachary A. | Jun 11, 2008 10:48:39 AM
B of A's Lewis is calling for a Q3 peak in the credit crisis. Anyone remember his last call for a peak? TIA
Posted by: karen | Jun 11, 2008 10:49:03 AM
I think your description of the market not working is, in fact, demonstrating that the market does work. Reckless lenders are now reaping the rewards of their actions. A functioning market does not require that no one fail, only that those who take on additional risk in search of outsized rewards be fully liable should those bets not pay off as expected.
And don't get me started on how government regulation contributed to this mess by mandating the need to lend to borrowers who previously would not have qualified for a loan. :)
~~~
BR: That's the point -- the Invisible hand should have prevented these companies from making absurd loans that was against their long term self interest in the first place.
Sure, a few 100 firms are now gone -- that was inevitable.
Traditional Free Market Theory suggests that they should not have done so -- and now the global economy is digesting trillions in losses.
Posted by: Matt | Jun 11, 2008 10:50:21 AM
On the contrary, almost all the people involved in the mortgage disaster were acting rationally in their own self-interest. As individuals, they maximized their own welfare (at least they thought so at the time), but not necessarily the long-term welfare of the company they worked for. The interests of the workers and the company did not align.
The same thing happened at a larger scale. Moody's was paid to rate securities, not to make sure the securities were sound.
This is a major failure of the incentives in the financial firms: People are paid to make the deal, not to make deals that make sense.
Posted by: Rex | Jun 11, 2008 10:53:17 AM
"one of the basic tenants of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise."
i call your false with another false. the tenant that you reference regards the individual, but your argument is against that of the group.
Posted by: Jack Stevison | Jun 11, 2008 10:54:49 AM
Two thoughts:
1. I think anarchical libertarians play a self-defeating game in not realizing that lack of some regulation can increase the probability of very bad regulation when crisis comes. Minimal good government will serve us all better than no government followed by the reaction to crisis that follows--particularly if the libertarians work hard to make government incompetent by repeatedly drowning it in the bathroom.
2. Responding to Phil's comment above: True enough. Cheap money can exacerbate or even cause a market failure--one can say it is the failure because it isn't the market in operation. But I think many will rightly argue that cheap money was not THE problem--e.g. if money is cheap and tall buildings are produced by builders--and then they fall down--we don't blame the cheap money. We blame the poor building standards, the lack of building regulation.
Posted by: General Specific | Jun 11, 2008 10:56:16 AM
Barry,
I take issue with the assumption that free marketers all believe that "human beings are rational, self-interested actors." Self-interested? Yes. Rational? Highly unlikely (at least not at all times.) The Austrian school of economics, as well as many in the Public Choice school, do not subscribe to this view point. I wish I were more eloquent on the matter, but unfortunately I am not.
Not all free marketers subscribe to the purely rational, EMH nonsense.
As already commented, the Fed's implicit put created a massive moral hazard. Simply, the banking industry, the Fed, & the this administration were attempting to avoid losses. By doing so these three groups (as well as real estate "investors") allowed for more risk to be accumulated since they were intent on socializing the costs if anything ever happened.
Not all free marketers subscribe to the purely rational, EMH nonsense.
Regards,
TDL
Posted by: TDL | Jun 11, 2008 10:57:22 AM
It's easy to call for more regulation. What's hard is to design (and apply) regulation that actually solves the problem without creating others.
The root cause of the mortgage mess wasn't so much a market failure, but rather a working market in a peculiar state. The normal state of markets is for an increase in price to reduce demand and increase supply. For a time, we saw the housing market enter a bubble state, which I define as being one in which increases in price increase demand significantly faster than supply can be increased.
These markets do eventually return to a normal state, though often with significant dislocation.
Returning to the subject of regulation, exactly how would regulation recognize and deal effectively with this root cause of the problem?
Posted by: Estragon | Jun 11, 2008 10:57:43 AM
"One of the basic tenants of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise. Humans can be illogical, irrational, and overly focused on the short term." -- Barry R.
TRUE. Profoundly true. But the rational actor is not merely a proposition of "laissez-faire economics" -- it is the core proposition of the Efficient Market Hypothesis (EMH) and much of classical economics. And because this proposition does not account for bias, delusion, irrational exuberance, and herd behavior, it means that most of the underpinnings of economics and capital market theory are just flat wrong.
And that in turn helps explain why not one economist in a hundred has ever successfully predicted a recession. And why central banks can never add value in attempting to 'manage'
the economy.
Economics is not a science. It's a degraded form of witchcraft, whose incantations and spells aren't even effective. Ben -- GET A BROOM!
Posted by: Jim Haygood | Jun 11, 2008 11:00:33 AM
karen-
Q2 peak....was done in late Jan. early Feb. from what I recall. Can't find the original link though...
Funny how they keep calling it peaked before the election.....no one dare make a public call for 2009
Ciao
MS
Posted by: michael schumacher | Jun 11, 2008 11:01:11 AM
The fed sets the rates, the treasury prints the fiat currency and 'regulated' banks create more credit. It's a top down deal, Barry. Hardly a characteristic of 'laissez-faire'. Add the political interests into the mix, i.e. encouraging bankers to make loans based on skin color or ethnicity rather than the ability to handle the obligation, and we get to where we are. Of course, people are not always 'rational'. Greed and envy are irrational but very human responses to all kinds of situations. If people were rational demogogues would never get a vote. Peace, love and happiness, man, yeah, that's the ticket!
Posted by: Tom C | Jun 11, 2008 11:01:37 AM
I 100% agree with you Barry.
To your quote "Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results."
To your quote I match one from Benoit Mandelbrot "If reward and risk make a ratio, the standard arithmetic must be wrong. The denominator, risk, is bigger than generally acknowledged; and so the outcome is bound to disapoint"
This is all human nature playing out. It shocks me that some of the biggest wizards on wallstreet don't understand this. Or maybe it is their job to pretend like they don't.. Afterall, this is how they make money....
Leverage is used to ensure the over profit from a particular investment. An investment is something in which a person puts money in for the eventual profit in the future. A short term investment is what was made of housing once you tuned the profit curve to a much more shorter window. This was magnified by leverage. The tuning was a function of 'greed' <- a natural human phenomenon. Who gave access to credit? Who gave access to excessive leverage?
Often times it is observed that non-intelligent agents aren't rational during non-norm conditions... They appeal to their more primitive natures most easily... Non-norm condition was presented : Free money/credit... They acted irrationally as expected. To suggest that those of intelligence unknowingly presented these perfect conditions for disaster for their short term profit is unthinkable.
I look around America and I see a very disorderly distribution of money, success, and a whacked pyramid of desires. Everyone wants to be a $$$ man because we have built a society/culture that only cares/values $$$$....
> Create a Goal/Level of attainment (Sky high) : Be ultra rich .. Live lavishly
> Create a system which rewards bad behavior/any means necessary philosophy to obtain said goal.
And you most certainly will get a disaster. I have grown up some 18 years of my life observing such a thing called 'Business' from my father who worked at Citigroup. Needless to say I went the totally opposite route and pursued engineering. For in that 18 years of my life, I saw the most worst characteristics of human beings on display in the name of business and money.
It is even shocking now that your average engineer/physicists/scientist have given way to their passion/desires to pursue business/$$$ whether it be as quants/wannabe MBAs, etc....
You want the system to right itself? Redistribute wealth to the innovators of a society. The people who go to work everyday to make it better and create something of substance or the people who work to sustain it. Stop a system by which people who serve no immediate purpose and only serve to rape/pillage the underpinnings of people's hard work make the most amount of money. Get some substance and fundamental purpose back into society. What exactly/How exactly do you think people make money by figgeting around numbers all day (and lots of it)? By indirectly taking it from people who go to work each day who mine the resources and produce the products that make a fiat currency worth something.
What has happened and what will continue to happen until this changes is high inflation and misery. You can't expect and less from an economy in which you have 40% of the people going to work each day 'working' and 60% of the other people sitting around profiting from it. It's economics/human nature/fundamental law 101.
Regardless of my words which my fellow money making friends say are worthless unless I make money <- funny that.... I have yet to be wrong on many of my predictions since I started back in 06'.... and that will be the case because I understand the fundamentals and I understand that timing wise we have evaded them for far to long and that they are coming back. No intervention or scheme will stop them and it most assuredly will be an ugly battle that will be lost.
Regardless of what I have to say and whether I continue to be right/wrong, understand that there is a fundamental operation of things and, if you evade that fundamental operation, you might get away for some time. However, you better feel rest assured that some day you will have to return. How painful that return is will be the delta between where you are at and where the fundamentals are at and the acceleration towards that fundamental level will be exponentially tied to the amount of time you avoided it. A wonderful depiction of life is found in the fibonacci spiral... It wonderfully depicts our short term thinking, our sentiment of feeling we know it all at times when we know hardly anything, the universe, software development, exponential progression, ... soo many things. The beauty of knowledge and wisdom is that it is only parted on those few who seek it for its on sake and not for its wisdom. Wallstreet has some wonderful tricks and formulae. However, they will never have the real goodies and those are the 'fundamentals'. Why you ask? Well, their fundamental nature contradicts them =P.
- Good Day all
Posted by: jombi | Jun 11, 2008 11:06:24 AM
Here in Miami anyway...much of what occurred was outright fraud and illegal in many many areas...combined with competely idiotic underwriting by lenders reaching for yield and fees ect ...would be better if they followed existing regulations and standard investment practices...how can anyone justify better than 30 times leverage as way of life...the rating agencies and the I banks are the most culpable imo..because they manipulated the system and should have known better ...does anyone think the collection of knuckleheads in our congreess and or the rest of our govt is any match for the private sector brainpower..?
Posted by: brasil | Jun 11, 2008 11:08:07 AM
"basic tenants" should be "basic tenets," a near-homophone.
No, I am not gay bashing. LOL.
~~~
BR: Fun with VR -- I'll fix above
Posted by: Jim Haygood | Jun 11, 2008 11:08:59 AM
Like other commenters, I disagree that actors here were doing anything but acting in their own self-interest and further, that regulation would have prevented this catastrophe. But just to sum up the big points of how regulation / fiat got us to this point:
- fiat currency / easy credit = divorcing scarcity from money leads to creating too much money, mispriced assets, malinvestment
- fiat legal structures = principle/agent problems. Securitization of assets where ownership is entirely muddled. Actors behave in their own self-interest, which can be completely at odds with the interests of the principle
- stupid tax incentives = enabling folks to pay more for houses thanks to tax deductions. Incentivizing people to trade up on their houses b/c of tax-free capital gains.
- GSEs -- a dumping ground for loans (further layers to principle/agent problem)
I'm sure there are more minutiae to the above examples (and a few more broad examples to boot). But it seems obvious that the biggest drivers for the bust here are founded on fiat/government-intervention as used by self-interested actors.
We haven't had a free market for a long time.
Posted by: Justin | Jun 11, 2008 11:10:12 AM
Markets eventually punish stupidity, but those affected rarely have the patience to wait that long. This impatience spawns calls for regulation.
Posted by: dwkunkel | Jun 11, 2008 11:16:37 AM
BR offered:
Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results.
observation: Absolutely, but it is also human nature to have a protective instinct that makes sure that someone else is left holding the bag. People don't rob banks with guns because they know they won't get away with it. This is evidence of logical, rational, thinking behavior. Rules always have loopholes and knowing where to find them and how to exploit them is a valuable skill that only looks like slackerism to the naive.
People will always accept free money whenever it can be found. GS and others are exploiting loopholes in the oil markets and we are all paying for their cleverness. Of course, having an Executive Branch in Washington that thinks this type of predator behavior is evidence of a normal functioning market doesn't help the rest of us.
Regarding credit markets, being able to stick someone else with a bag that holds a stinking carcass is normal, rational behavior. Having the environment that allows this behavior is evidence of government failure. It is a proper function of government to make laws and offer police protection so that slackers, slide by artists, and criminals can't legally crap on the rest of the population and will think twice before trying.
What you describe is actually the highest level of supply side, trickle down economics in action, according to some who would otherwise be regarded as idiots, criminals, or parasites if there weren't so many of them.
Posted by: cinefoz | Jun 11, 2008 11:17:48 AM
I will add a couple more insights on to my previous post.
Thinking of our planet, an atom http://www.cfo.doe.gov/me70/manhattan/images/AtomLabeledLarge.gif, the universe, orbits, fibonnaci sequence, chaos, fractals, flowers/seeds... What's the commonality? The purpose/substance/order being at the center with wild orbiting nothingness at the fringes. Evolutionary nothingness/chaos from subsequent iterations of a fundamental basic unit. The seed of the fractal. Look at markets. Look out the expansion of markets... And the subsequent parallels to some of these things. LOL, there is beauty in the design.
Posted by: jombi | Jun 11, 2008 11:25:09 AM
BR: please, most human beings are not the perfectly rational creatures of economic theory. They are stupid, greedy, selfish, gullible, emotional and a host of other adjectives. And contrary to the assertion by Mr dwkunkel markets often don't punish stupidity and greed as we know from the myriad cases of O'Neil, Prince, Mozilo et al. Whether we like it or not regulation is required for the public good. It may be an imperfect mechanism but do we really want to leave the efficient and honest operation operation of our financial institutions in the hands of the endless procession of individuals we've seen fired and/or indicted over the past seven years. I actually think the greed and irresponsibility of these people when 80% of Americans have seen their situation worsen is going to lead to a massive backlash starting in November.
Posted by: John | Jun 11, 2008 11:26:43 AM
DOH! No sooner do I post a comment to the WashPost article than another article comes along....
Posted by: wunsacon | Jun 11, 2008 11:28:33 AM
Looks like I was cribbing your first paragraph, Barry. But, I swear I didn't!
Posted by: wunsacon | Jun 11, 2008 11:31:27 AM
Although people make irrational decisions, they are predictable. Flood the economy with money and you will get the same result every time. Take the money away and you have to have consolidation because there is no longer enough money to support all the players.The strong, smart or lucky survive. Politicians had no interest in stopping the boom in their states or counties because they would get booted out.
I say it was all orchestrated to give the central bankers more control of more money . When congress rebuffs Henry and the gang , another shoe will drop and we will be convinced it is in every one's best interest to have people we never elected control our financial situation.
Posted by: BR549 | Jun 11, 2008 11:31:49 AM
Wow...a lot of comments so far...in case it hasn't been mentioned, a crucial factor in the housing fiasco was the fact that "risk origination" (if you will) essentially became decoupled from "risk ownership".
Mortgage brokers originating loans held few to none for any substantial period of time - unlike the mortgage-originating banks of yore.
Instead, originated loans were largely sold off to investment banks who in turn would package them into residential mortgage backed securities (RMBS) whose cash-flows were designated (via the RMBS' legal documents) into different "tranches" with different risk-return characteristics.
The RMBS were then sold off to buy-side institutions around the world (most notably, hedge funds, who rose to prominence during the same period that RMBS did - a too-little-remarked-upon fact).
These hedge funds in turn relied (excessively as it turned out) upon the rating agencies' appraisal of the RMBS and the "reputation" of the investment bankers pitching the deal.
And, not to forget, the institutional buy-side had its own "risk-decoupling" issues - the vast bulk of the money in institutional investors is not their own.
Bottom line, once risk-origination and risk-holding become divorced via excessive "specialization", then intelligence and prudence get disintermediated as well...
Posted by: cas127 | Jun 11, 2008 11:38:54 AM
