The Economic Crisis

Better risk-adjusted returns than T-bills?

The system collapsed because the group on the right in the picture above - the residential borrowers - defaulted on their loans at a (predictably) unprecedented rate, which grew suddenly from the historic average of 1-2% to almost 50% by the time the practice of sub-prime lending ended.  The question is not “how did this happen?”, but “why did it take so long to stop?”.  Alas, like every financial collapse since the Dutch tulips, everybody was so busy passing a buck, and extracting their commission, that nobody bothered to check if the transactions made sense.  Why give your money to Alan Greenspan when some stranger you never met will pay you five or six times his rate?  All you had to do was ask.

In the quadrennial silly season of presidential elections, and with the public market indices  swinging like pendulums attached to loose nails, public uproar over the gross mismanagement at, say, the SEC, or abiding suspicions that the fat cats found yet another way to fleece the rest of us are making headlines.  It’s an easy story.  Everybody understands anger, greed, and deception.  And they are all easy to find in the mortgage crisis.  As I write this, government officials are spending yet another weekend working on the mother of all bail-outs, a new “trust” corporation that will accept - really, absorb - all the bad loans from the market for the purpose of cleansing the system of the dirt we collectively allowed in the pipeline.

The real culprit, though, is something called a NINA loan.  NINA stands for “no income no asset”.  If the public officials want to rebuild the economic levies, that is the place to start.  In the post-Reagan/Gramm era of deregulation, NINAs were perfectly legal, even ordinary.  If willing parties agreed a voluntary contract with the risks laid bare and the costs clear, the government agreed to get out of their way.  The assumption, false on the face of it, was that if the contract didn’t perform, the parties wouldn’t come running back to the government seeking help or redress.

Which isn’t how things worked out at all.  Instead of DIVERSIFYING their risk, the investors (on the left side of the picture, the guys with deep pockets) were unknowingly ACCUMULATING their exposure.

Only the names were diversified: Bear, Lehman, Merrill

All this happened below the radar because the folks who measure and assign risk (Moody’s, Standard and Poors, and Fitch) were using historical data based on NINA-free loans.  Furthermore, the investment banks, mortgage banks, and their respective brokers became rich off the transaction fees - so they had no reason to question the underlying process - and people who would have previously never qualified for large bank loans got the money and drove up the prices because there were suddenly so many of them chasing so few homes.

Winding the spring

This particular vicious circle was driven by the enormous supply of fresh capital from overseas (Americans aren’t saving much these days) and the large pool of newly created borrowers that appeared when the credit standards went from difficult (prove your income can support payment) to easy (promise with your signature that you’ll pay).  It was accelerated by the lenders who brokered loans to individuals, and then bundled the mortgages up by the hundreds and thousands and “sold” them en masse to the large investors.  Everybody was happy for a while, because the historical data was stable and strong.

The problem was a) there was zero diversification in their risk (all the loans were effectively the same) and b) the only barrier to unscrupulous brokers and euphoric borrowers was the the economic reality of “what happens later”, well after the commissions were paid and the new home “owners” tucked snugly in their new beds.  In other words, the incentives were wrong and the relaxed standards were dumb to the point of, well, criminal.

Today we know that the investors were either negligent or naive about the quality - the anticipated default rate - of the new loans.  Either they didn’t know or didn’t care that the standards had been so diluted.  We also know that the guys they paid to assess the risk were similarly cavalier;  “good as money” assets became worthless because the demand from new buyers disappeared almost suddenly as it had been created by the chicanery of NINA and her cousins.  Finally, the brokers and their customers engaged faith-based lending on an unprecedented scale, each of them playing with somebody else’s money, sometimes by manipulation, sometimes by exploitation, and in any case by the millions.  Faith was broken when a slew of new customers started missing payments, mostly because of built-in rate changes they should have known about but didn’t.  It unraveled quickly from there.

There are two easy ways to avoid this catastrophe in the future:  restructure the incentives properly, and adjust lending standards so that common-sense (never mind actuarial) judgment would restore confidence in repayment.  The commissions paid to mortgage brokers should be based on actual performance of the loan, not just the transaction itself.  A car salesman, for example, is an agent of the manufacturer, and makes no representation back to the factory about the credit worthiness of his customer.  He gets paid when the car is sold.  Lenders, on the other hand, sell their loans to underwriters based on exactly that assessment (effectively as agents of the borrowers), and they are well paid to do so.  The number of bad loans would have been dramatically reduced if brokers had to wait, like the investors themselves, if their recommendations were correct (or honest) and the loans performed.

The second means to avert this tragedy is to not lend more money to people than they can obviously repay, an inherently subjective judgment that has been horribly abused in the past (because of race, gender, or lifestyle).  This is a slippery slope, but somewhere between atavistic prejudice and exploitation is a fair if imperfect balance.  In the words of Barney Frank, chair of the House Banking Committee, this may be something we can “agree to do together”.