Are a bunch of monkeys running our financial system?

Great Debates
21

Where, exactly, is the risk for the decision-makers as individuals?

These financial-management honchos are paid countless millions of dollars to gamble with other people’s money. If they win, they get paid further countless millions, and they keep their jobs. If they lose, they are paid countless millions in severance, and shown the door. Then they get an unpleasant front-page WSJ story and they retire to one of their tropical vacation houses. Ooo, sucks to be them.

I don’t want to see an elimination in risk-taking, or a punishment for chancy bets. As you say, correctly, it’s the people who roll the dice who drive the engine most of the time (not to mangle a metaphor or anything). But when the people who make foolish bets pay no price for their stupidity, and in fact are rewarded, there is zero disincentive for foolishness, and indeed encouragement for it. And the current financial instability is due directly to great heaping helpings of total foolishness, due to a system that does not visit the pain of same onto its practitioners.

To be fair, the people who engaged in the foolishness are, by and large, not fools. Just the opposite, actually: they looked at the system, recognized there was no personal downside to this ridiculous bet, and spun the Roulette wheel with abandon. If their number comes up, everybody wins. But if the spin goes bad, it’s everybody else who goes broke, and these guys lose basically nothing. They’d be fools not to make that bet.

That’s what’s being debated here, not some straw-man notion about the total elimination of risk. :rolleyes:

22

The run-up in the real-estate market was a speculative bubble. Inflation-adjusted home prices increased 70% in just the past 12 years, and the fact that banks could now sell mortgages easily in the secondary market gave them far less incentive to vet the prospective buyer. The “pop” was somewhat delayed because when the stock market bubble collapsed in 2000 that money went into real estate, and unlike other speculative bubbles there were real, tangible assets (i.e. the homes) the investors could point to.

Yes, a lot of people got a mortgage they couldn’t afford. That’s no surprise, given that the most knowledgeable person in the room when the deal is signed is the mortgage broker, and he/she has a vested interest in getting the deal done and no responsibility for the deal going south once the mortgage is sold off to investment bankers.

But the run-up in housing costs was caused by speculators buying up the market, speculators who were more than happy to use the ARM’s offered by banks as easy credit for a property they planned to flip before the adjustment kicked in. Calling it a “sub-prime” crisis implies it was all just a bunch of spendthrift consumers living beyond their means, a way for the investor class to blame it all on “those people”.

23

As CJJ* says, it was a bubble. The problem with bubbles is knowing when they’re going to burst. The bursting is usually forecast way in advance, but someone who pulls out say a year before loses the profit that could have been made in that year - and before the burst, looks pretty stupid.

It’s easy to say that if everyone weren’t stupid, this wouldn’t have happened, but I don’t think that explains it. Problems like this occur from each person doing what makes sense locally contributing to a mess globally. That’s really the justification for regulations - it prevents people from doing things in their best interest that will eventually screw society as a whole.

Let’s look at the players. Some homebuyers were lied to, but others were working on an assumption of a rising market and stable or lowering interest rates. If you want to buy a home, but are locked out by conventional loans, why not get an ARM assuming that the house price will increase, allowing you to refinance, and that interest rates will decrease, also allowing a refinance before the ratcheting up.

The lenders who should have know this was an unstable situation sold the paper, so defaults became someone else’s problem. This kind of stuff didn’t happen when banks sold and held mortgages. Making a market for mortgage notes increased the money available and probably increased their availability and decreased interest rates - but maybe increased the availability of mortgages a bit much.

The people who bought the notes thought it was fine because only a tiny fraction would default, and anyhow in a rising market a foreclosure was a small loss. Plus, some of the notes were incorrectly rated AAA.

And finally, the risk meant high returns, and most companies couldn’t resist. A few of them got caught with lots of paper, those are the CEOs getting canned. The Times has an article about one - Bear Stearns I think, who was conservative and didn’t get hit at all. But few wanted to explain to their stockholders why they were making less money than the house next door.

If no one had used the equity in their homes to buy things, we probably would have had a recession a long time ago. If everyone were like me, 10 year old car and no debt, this country would be in a mess. So, who’s stupid? I don’t know. I do know that forcing lenders to not make loans to people who clearly can’t afford to repay would have helped a lot, and might have led to a soft landing as opposed to the disaster we have now.

24

I agree with most of what you said, but here’s the thing. How does one determine if a person “clearly” can’t afford to pay, and who is the best person or agency to do that? It all depends on the economic assumptions you make. As you noted, it can be bad for the economy to be too conservative, too.

I don’t know about you guys, but the “greedy capitalist” in me sees a chance to make some money here. In fact, I was just discussing this very thing with a buddy last night. Maybe we’ll screw up and make some bad investments. But that’s why I spread my investments around-- to minimize the risk.

25

I suspect that the standard credit checks do pretty well. You’ll never get zero defaults, but the rate was a lot lower before this boom started.

But you’ve got to think that those people giving out loans without income checks of any kind weren’t even trying to figure out if someone could pay. I understand that self-employed people need special handling, but this went way beyond that. I suspect the best solution would be to require that loans granted this way be marked JUNK in large friendly letters. If someone wants to take the risk, fine, but from what I read there was a certain amount of misrepresentation going on. It might well be that some of the buyers of the paper were working hard at not seeing the risk, but I’m not sure.

26

Sometimes this gig has it’s great moments.

From The Marietta Register, early October, 2007

Confessions of a Sub-Prime Lender

We got one of these guys to talk anonymously about his experiences working the sub-prime market. It doesn’t paint a pretty picture.

27

As we often say around here…Cite? This sounds more like an excuse than anything else.

28

Part of the problem was that executives would get bonuses during years of profit and little or no punishment when the chickens came to roost.

Also, securitization permitted a fun and varied game of musical chairs among lots of financial players. Write a no-document loan (or liar loan)? No problem! Just sell them to an investment bank, which would then fob them off on a third party. The third party buys it because well it’s diversified and besides it was sold to us by a top bank! How could anything go wrong (said the NY spider to the FL fly)?

Besides, the computer models say that the bundle is safe. Of course the data underlying those models doesn’t reflect liar loans or teaser-rate subprime combos, but hey, we made adjustments!

Who will be the bagholder?

Incidentally, the go-to site for the latest on these shenanigans is http://calculatedrisk.blogspot.com/ . eg What is subprime? Recommended.

29

Sorry to butt in, but I happened to recall this one. There was a 1995 metadata analysis by the Chicago Fed Letter (a trade publication for banks) called Discrimination in mortgage lending. I had heard of it because Bank of America is headquartered in Charlotte, and it began a two-year advertising and public service campaign to recruit more minority borrowers, from individuals to small businesses. The local papers said that it was a response to CFL’s findings.

30

I agree with you; it has to be 3. No way in hell they couldn’t have seen this coming. And now Bush is trying to stave off the inevitable by bailing out all the idiots who signed up for these ridiculous loans. I find the whole thing unfair and insulting to all the responsible people who haven’t been able to buy homes and had enough sense not to take out a loan that they wouldn’t have a snowflake’s chance in hell of making the payments on. Again and again, stupidity seems to be rewarded.

31

Not monkeys, rather mathematicians.

32

My guess is:

  1. Whilst reputable financial institutions knew that shonky loans were being made for upfront commissions they thought the risk in the securitised loans would be sensibly priced by the market;
  2. They each thought their own behaviour too small to affect the functioning of the market;
  3. They thought the size of the sub-prime market and its likely pricing meant that the exposure of their creditors and customers to sub-prime lending unimportant to their own financial health;
  4. They thought the overall liquidity of the financial system was not an issue because of their confidence in central bankers.

The central bankers have not failed yet. In the event that system-wide liquidity collapses things could get really, really ugly.

33

Don’t forget about the chief monkey in all this mess, i.e. the Great Enabler Greenspan.

If you believe in the power of the free (i.e. unregulated) market, then when that market creates losers, you need to let them lose and feel the pain of making an incorrect investment. Constant bailouts, and/or the "Greenspan put "do not encourage market discipline. Risk becomes a non-factor as Cervaise pointed out. Deregulation appears awfully one-sided.

Was regulated. Glass-Steagall was repealed, and many other consumer protections have been gutted either by court decisions or more recent legislation.

This month’s American Prospect has a good review of Greenspan’s autobiography, as well as a good article about John Roberts and the Supremes which sheds some light on how the monkeys got in charge of the playground.

Our corporate tax laws do not necessarily help either. The ability to carry losses encourages companies to take a big bath every few years to protect profits during the other years.

I would like to hear other’s opinion on how this helps the function of free markets, since to me it only seems to encourage speculation over true investments in productivity, i.e. let’s make a bet, we can just write it off if we lose.

I know individuals have the same ability to carry losses (and to do so indefinitely, but there is a slight difference in scale between the two).

34

No problem with the butting in, but this is not really what I was looking for. I.e., I don’t doubt that the feds were concerned about discrimination in borrowing but what I do doubt is that the implication that it is somehow the concern of lenders about being charged with such discrimination that has led (or even significantly contributed) to this whole subprime loan financial crisis.

35

If there were such thing as a cross between a jackal and a lemming, I would gainsay you on the ape point. The money business is full of jackalemmings.

36

Jackals are not predators. They’re scavengers.

If someone finds a way to profit through screwing homeowners foreclosed upon in the subprime crackdown, that person will be a jackal.

Our financial community as a whole might better be characterized as fat but hungry, and smart but unintelligent.

37

Hey now, that’s not fair. I am a card-carrying member of the financial community, and I’ll have you know I am thin and unintelligent.

38

Correction to your correction :wink: - like Spotted Hyenas, jackals hunt more than they scavenge ( a favorite prey of the Black-Backed Jackal is the little Thompson’s Gazelle - a hunting pair has an average 67% success rate in taking one down ). Also jackals are omnivorous. One study put their consumption of mammals at only ~33%, only a subset of which would be scavenged. The rest ( almost certainly non-scavenged ) consisted of birds, reptiles, invertebrates, fruit ( 13% ), etc…

Err…okay, a truly needless hijack, there. Carry on :p.

39

Couple of my own pennies to add…

The major financial institutions are not the primary lenders in this death spiral. The homeowners could not get the mortgage from them and had to visit the sub-prime lenders to get the mortgage at a higher rate. The sub-prime lender then packaged up a bunch of their loans and sold them back to the big banks (including the international institutions). The big banks gladly took these with the higher rates without fully assessing the risks. Sometimes the bad loans were wrapped up multiple times and successfully disguised, but honestly, you’d think the banks would be clever enough to be able to identify them.

I find this statement (from the original link) sobering…

I’m starting to consider selling our house now and renting for a couple of years…I’ve got some equity built up and it would just kill me to lose that when the correction hits the whole industry (increased inventory due to foreclosures and retiring boomers downsizing/moving/renting).

40

It was reported that Countrywide (and no doubt others) were profiting from charging large fees to its clients who were at risk of foreclosure - fees for lawyers, for assessments, etc. So I think the jackal label fits well also. (I can dig up a cite, if anyone doesn’t believe this.)