It goes a long way to explaining why so many people did such silly things during the boom: They were well paid to do so!
A quick excerpt:
The incentive structure that arose for firms in this specialized industry set the stage for
the collapse. The incomes and fees generated are all
transactions-based, that is, payments are made at the time the
transaction is recorded. The originator of the loan, typically a
mortgage broker, is paid at the time the contract is signed. Brokerage
fees have varied between 0.5 and 3.0 percent. The mortgage lender earns
a fee, between 0.5 and 2.5 percent, upon sale of the mortgage. The bond
issuer is paid a fee, typically between 0.2 and 1.5 percent, when the
bond is issued. On top of this, the rating agency is paid its fee by
the bond issuer at the time the security is issued. All these fees are
earned and paid in full within six to eight months after the mortgage
contract is signed by the borrower.
Thus, no party to the mortgage transaction has any economic stake in the performance of
the underlying loan. In fact the mortgage broker is paid a larger
percentage, termed a “yield spread premium,” if he convinces his
clients to accept a higher and more default-prone interest rate. With
this structure of incentives, it is not hard to understand why any
risky loans were originated, financed, sold, and securitized,
especially during the period of rapidly rising house prices from 1999
through 2006. With expectations of rising house prices, it is also not
hard to understand why pools of these loans received the imprimatur of
a credit rating agency when offered for sale.
One does not need to invoke the menace of unscrupulous and imprudent
lenders or of equally predatory borrowers to explain the rapid collapse
of the mortgage market as house price increases slowed in 2006, before
ultimately declining. There were certainly enough unscrupulous lenders
and predatory borrowers in the market, but the incentives faced by
decent people—mortgagors and mortgagees—made their behavior much less
sensitive to the underlying risks. The only actor with a stake in the
ultimate performance of the loan was the mortgagee. Everyone else had
been paid in full—way before the homeowner had made more than a couple
of payments on the loan.
“Why am I being punished for having bought a house I could afford? I am beginning to think I would have rocks in my head if I keep paying my mortgage.”
-Todd Lawrence, Norwich, CT homeowner with a traditional 30-year mortgage
Herein lies the simple problem in trying to “save” so many mortgages: A huge swath of them should not be saved.
Some of that is due to price, some of it is due to not wanting to
reward irresponsible behavior, but the bulk of it is simply because the
people living in these homes cannot reasonably afford to pay for them,
even after a 20-30% workout.
There are now more than 10 million “home-owers” underwater, with
their mortgages greater than the present value of their homes. Since
they have little skin in the game — thanks to banks that did away with
down payment requirements — there is little incentive for them to tough
Not surprisingly, it is FDIC Chairman Sheila Bair who is leading the
push towards a mortgage workout plan. She wants policy makers to take
action to help people stay in their homes — thereby taking pressure off
of the FDIC, which insures the banks.
Why? More foreclosures = more bank failures = bigger FDIC obligations.
The problem with this current rescue plan is that it is designed to
“prevent the continued downward spiral of the housing market.” But that
is EXACTLY what the housing market needs — overpriced homes that are
not selling need to come down in price. We had a normal price increase
from 1996-2001, and then a near vertical set of price gains from
2002-06. Any framework for systematically modifying loans that fails to
comprehend that is doomed to failure.
As the election closes out amid the wet squelch of the economy, it's
worth looking forward toward the Obama transition. In the past, I've
wondered about who would be holding down the fort at Treasury. Jon
Heilemann answered that in this week's New York magazine:
". . . the inside betting is on a Larry Summers encore. 'They’re gonna
want somebody who knows the building, knows the economy, has been
confirmed before and been advising them on economics,' says the former
Clinton aide. 'I’d be flabbergasted if they chose somebody else.'"
Former U.S. Securities and Exchange Commission Chairman Arthur Levitt
talks about the importance of credit derivatives to the financial
markets and the need for regulation and transparency, and the outlook
for executive compensation at financial firms. Levitt is a senior
adviser to the Carlyle Group and a board member of Bloomberg LP, the
parent company of Bloomberg News.
Here’s the latest act of idiocy: Blaming the media or the Bears for the credit collapse and market crash.
This not only demonstrates a total lack of understanding as to the
difference between causation and correlation, but it evinces an utter
disregard for the way the economy and markets operate. makes about
A classic example of this form of brain damage can be seen on the comments of a recent Floyd Norris blog post, Consumers Drag Economy Down. Norris notes, (as we did earlier today) “Consumers
are clearly in retreat, and the economy is suffering. The
year-over-year increase in real G.D.P. is 0.8 percent, the lowest for
any four-quarter period since 2001.”
It didn’t take long — the second comment actually — before the
‘tards actually started blaming Norris for the collapse. Let’s see what
Mark D. had to say:
Great. You guys are posting stuff that will create a self fulfilling prophecy.
Yes, it was all Floyd Norris of the New York Times who cut rates to
1%, and then kept them there for a long time. And, it was Norris who
forced the banks to lever up 40X. It was he who forced the rating
agencies to slap a triple AAA on junk paper, it was Norris who mandated
that hedge funds, trusts, pension funds and other buy this junk
paper.And of course, it was Norris who forced all those mortgage
originators to write those NINJA loans, and all those home buyers to
take 2/28loans they could not afford when the reset occurred.
Why does the internet cause people to turn their brains off? Does
anyone ever think for even a second before posting nonsense like this?
Self-fulfilling prophecy? Here’s a self-fulfilling prohecy: Write
thoughtful intelligent commentary on the economy, and a large swath of
humanity will trip over themselves trying to demonstrate why IQ test
are given on a cuvre.
A few other observations:
1) Because the NBER has not yet declared this a recession only means
the official start and end dates are unknown. A recession can occur
regardless of their declaration.
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