Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Friday, September 19, 2008

Moral Hazard and Morality

The central problem with the Wall Street bail outs is something called "moral hazard."  

Moral hazard problems arise when actors know they will not have to suffer the costs of risky behavior.  Free market based criticisms of the IMF argue that when the IMF rushes in to save banks from financial crises in developing countries, the IMF is encouraging a moral hazard problem.  

The current banking crisis has its roots in a moral hazard problem.  As Dr. S. neatly summed up in his early comment bankers "were perfectly responsible and rational.  They knew they would get rich when the big risks worked out and would get bailed out when they did not."  

Now you might say that individual mortgage borrowers were also investing under a moral hazard situation.  But can we really think that a blue collar home buyer with questionable credit really expected to be bailed out if they couldn't make their house payments?  No.  I argue that the reason those people took excessive risks was that they were deliberately mislead by the banks and encouraged to take greater risks with promises of a never ending housing boom.  
And this leads us to morality.  We have a situation where the banks knew that THEY would be bailed out if they wound up with great piles of bad debt.  But they did not fully inform the home buyers of the risks to anyone.  Instead they relied on their privileged knowledge of government intentions and policy possibilities to aggressively encourage people to take enormous risks that would only serve to benefit the bankers.  

I wonder what the so called Christians who love Sarah Palin so much would think of that kind of behavior.  


The Law Talking Guy said...

That sort of Christian who loves Palin also thinks the dinosaurs were mythical, and the world was created in six days about 6000 years ago (so does Palin). They totally use their religion as an excuse to ignore reality. I've read creationist crap - they really just lack fundamental education. These people have no ability to comprehend any of what RBR just said.

Spotted Handfish said...

I don't know if I agree with you RBR. As far as housing is concerned people were lead to believe that houses would never go down, but anyone with an understanding of economics would realise that that situation was not sustainable.

Likewise banks were working on cheap credit and playing a game of hot potato with bad debts. Maybe they did have a better understanding of the potential bad debt but they were under a different pressure: they had to make profits. Being cautious in a bull market does not win you any clients and gets your stocks slapped. The best they could hope to do would be to jump out at the right time, and it's near impossible to time that.

So I agree there is an issue with moral hazard being removed, but this has mainly happened with Fannie and Freddie. What I think is cause of the problems in other institutions is the glut of cheap credit over the last decade. This is really government policy trying to avoid recession at all costs, with the USA and Japan being the main offenders.

So I wouldn't totally agree with Dr S's summation. Rather I would say they were perfectly responsible and rational, they couldn't do anything except follow the herd to make their shareholders happy. My opinion is that the bailouts are necessary to stop the whole system imploding.

Raised By Republicans said...

Of course individuals are responsible for their own investments. And most people who are sophisticated denizens of the world economy will know the risks. But everything that I've heard (and experienced first hand) about banks during this period is that they mislead people about what their credit limits really were.

When I went to a bank and asked them what they would loan me for a new house they quoted me a figure that was more than $30,000 higher than I had figured I could afford. To coin a phrase I said, "Thanks but no thanks" and borrowed only what I thought I could afford. But the banker pressed me repeatedly encouraging me to borrow more. They did the same thing again with my car loan. I have also heard stories of even more aggressive lenders. My real estate agent told me stories of lenders outright lying to borrows about the prospects for interest rate increases.

Yes, you are right Spotted Handfish that an intelligent and justifiably skeptical borrow/consumer would not believe such tales from bankers. But that such misleading tales were frequently told here in the US is now not widely disputed.

I think individual borrowers are entitled to ask, "why is that when AIG makes bad investments they get an $80 Billion bail out but when I do it, I'm told to suck it up and take responsibility."

I realize that AIG means more to the system and that the bail out was probably necessary. But I can still express outrage about the circumstances that brought us to that necessity and sympathize with those people who over leveraged themselves into bankruptcy to buy an over priced house.

Dr. Strangelove said...

In the 1980s, the Savings & Loans scandal brought down lots of institutions, but there was a huge bailout. So there was even precedent. Sadly, I think it is very reasonable to believe that big companies figured that they would not bear the full brunt of their losses. Unlike homeowners, who are tossed out onto the street, investment firms always knew there would be golden parachutes, sweetheart deals, and lots of concerned US officials telling taxpayers that these companies were "too big to fail." While Handfish is surely correct that day-to-day operations were all about pleasing shareholders, the reason nobody stopped to say, "wait, what if it all goes bad?" is that they knew it would not be allowed to get that bad. Something would give. In this case, we all give. To them.

Spotted Handfish said...

Good point, RBR. A friend here in Australia once told me he had been offered a loan which would have taken all of his take-home pay to service. The point I was trying make was, as home buyers went in to the market given the threat that homes would never get cheaper, banks dipped their toes on the basis that they had to maintain the same profit levels as others. You can't be left behind.

The interesting thing to me is that somehow the Fed and Bush -- and their equivalents around the world -- let these known bubbles build for so long.

The pity, as RBR rightly points out, is that the housing market is in smaller pieces and hence more robust than the few financial firms that the governments cannot let fail. Small comfort to home owners I know. I wonder whether it is the firms they are trying to save or the system?

So my question to Dr S is do you have any evidence that investment firms were relying on being "to big to fail"? I haven't seen anything to that effect.

Raised By Republicans said...

Spotted Handfish,

I don't think this constitutes hard evidence but the fact that such high risk investments were so widely held by such big banks suggests to me that they were not getting (or acting) the risk signal being sent to them by the interest rates.

It's really very similar to the SE Asian financial crisis (which was also caused largely by a real estate bubble - only there it was commercial real estate). Banks were investing willy nilly in high interest projects much more enthusiastically than the risk should have warranted. But since they had good reason to believe that the IMF would bail them out (which it did), they saw the interest rates only as a signal about the return on the investment, not as a signal about risk of default.

High risk/High interest investments should be rare. That so many banks were so deeply involved in these things should indicate that they were not getting the risk part of the price signal.

Raised By Republicans said...

By the way, I agree with Spotted Handfish that it is somewhat surprising that regulators in the US and around the world seemed to see this coming for a couple of years at least and did little to change it.

Perhaps the problem was that right wing politicians were in charge in much of the main financial centers as the crisis loomed: Washington and Tokyo both had right wing heads of government for most of this period. The EU is, of course, mixed. But the Council's version of finance ministers (ECOFIN) would have had enough right wing representation (France, Germany, Denmark, Poland etc) to at least prevent bold action to regulate before the crisis hit.

Raised By Republicans said...

Gee, Spotted Handfish, you write very complicated little posts.

In the SE Asian Crisis the emphasis by the IMF was on saving the banks not on fixing the system. Joseph Stiglitz's book "Globalization and Its Discontents" is quite good on this. And his substantive interpretation is largely backed up by Jagdish Bhagwati in his book "In Defense of Globalization." If Stiglitz and Bhagwati agree, I'd say it's got a good chance of being on to something.

Dr. Strangelove said...

RbR says it fairly well. The astonishing financial positions of these firms (e.g. 30-1 debt-liquidity ratios) is at least highly suggestive that they anticipated that they would not suffer the full effects of a fall. When you see one person walking on a tightrope, you can shake your head with amazement--but when you see a hundred people walking on that same rope, you should look for the net. The repeated bailouts--from the S&L crisis, to the Airlines after 9/11. to the SE Asian crisis RbR mentions, to Bear Stearns earlier this year--is evidence that this bailout practice is hardly uncommon. Everytime a big company starts to flounder, the government starts talking bailout. Every time. Lehman Brothers was news because they didn't act. Frankly, any CEO of a huge firm who looked at history and did not anticipate hard landings would be cushioned was ignoring history.

Why not guarantee the mortgages, instead of buying them?

Spotted Handfish said...

But you see they were following the identified risk. Both Moodys and S&P were employed to provide risk assessments on the assets that were being sold (repackaged mortgages) and were rating those as AAA. The risk was not being translated well, as has been acknowledged. There is no doubt that the disconnect in pricing in risk caused a lot of these problems.

Naah, I'm too jetlagged from attending Dr S's nuptials to think this through. Is 3am too early for coffee?

The Law Talking Guy said...

As someone who bought a house in 2007 (out of foreclosure, btw, paying down the 80% note and getting something of a bargain), I was very motivated by the fact that housing prices had soared and historically never declined by more than 10%-15%. Buy now or never be able to buy. Lots of us believed it. And it's frankly still true. In most parts of the country, housing prices have maybe declined no more than 10%, and that is from theoretical peak values rather than actual sale values. As someone who is praying that my house doesn't become worth less than the mortgage, I sympathize greatly with the tens of millions of other Americans in the same boat. And I'm pretty angry that the Democrats in Congress don't seem to be even willing to add extended unemployment benefits to the bank bailout. For all this, why does the bank get help, not the homeowner? Can you imagine if, during Shay's rebellion, George Washington had proposed bailing out the *banks*? It would have taken more than one column of soldiers to do the trick.

Pombat said...

Sitting on the flip-side of things, in my rented house here in Australia, with no credit card debt or similar because I believe in saving as opposed to instant gratification, I'm quite happy with some over-stretched people suffering mortgage pain and/or having to sell quickly/cheaply - they are part of my problem you see - by providing demand for overpriced houses, they ensured the prices would stay too high for me to buy. Having said which, I'm only happy if none of my friends suffer!

We know one couple here who actually own three places now: for a while they owned two and lived in a rental, as it made more sense financially for them to do so; they've finally bought one to live in themselves. I'd have no problem with them, and any other buy-to-let type investors out there, having to sell the ones that aren't their home.

And LTG, what does it really matter if your stated house value becomes less than your mortgage? Assuming you can still comfortably make the mortgage payments, and you're not planning on moving any time soon, it doesn't actually affect anything other than your pride - it's all just numbers. Negative equity is only bad when you have to realise it - if you can wait for the housing market to correct itself and go back to climbing, all's well.

I'm also not convinced that the banks were operating under a "we'll be saved" assumption, I think that most of them were just caught up in it all, loving the profits and good times too much to really sit back and consider things, happy to just trust the AAA ratings they were being shown, and making sure they didn't get left behind by everyone else, as that would've meant immediate pain for them.

Raised By Republicans said...

It occurs to me that something got missed in our discussion. One of the main points I was trying to get across was that banks involved in this mess were operating under conditions of moral hazard. The home owners being foreclosed upon were not. They may have been making bad decisions but they were NOT acting under the mistaken belief that they would be bailed out if they defaulted.

I would argue that their culpability can be mitigated somewhat by the fact that lenders were willfully misinforming borrowers about the risks involved in the loans in question. Pombat and Spotted Handfish appear to be less sympathetic.

To answer Pombat's question about why the paper value of your house matters...Suppose you are a 30 something college grad with mid level job in some company. You have a retirement plan that probably includes a stock portfolio. When the value of those stocks drop, you can ride it out. You would only realize those losses if you sold out. Pombat seems to be asking "why can't home owners simply ride out the down turn?" Answer: people don't hold houses as long. When I bought my house I was told that the average home owner in my city owned a house for 5 years before selling it.

I don't know about Australia in this respect but I do know that Americans are far more mobile than Europeans. Europeans are far more likely to spend their entire lives in or near the towns in which they were born. Americans change jobs more frequently and often change economic sectors when they do so. This often involves moving to a new city - which means selling your house. For example, since graduating from college, I have lived in 4 different cities. Two of those moves were to go to graduate programs it might be said that academics more more often. But my uncles who are not academics have moved frequently too. One of my uncles lived in Dayton, Chicago, and Cincinnati in the course of his career. Another lived in Akron, Baltimore, Pittsburgh and Columbus. Another lived in Chicago, Orange County, CA and Santa Barbara. I won't even talk about those relatives of mine who are also academics or in the military or are military contractors.

If we are facing a housing slump of several years, there could be no avoiding taking a loss on your house.

The Law Talking Guy said...

Pombat - it matters because you can't move under those circumstances where the mortgage exceeds the value.

Dr. Strangelove said...

Pombat writes: "I'm also not convinced that the banks were operating under a 'we'll be saved' assumption, I think that most of them were just caught up in it all, loving the profits and good times too much to really sit back and consider things, happy to just trust the AAA ratings they were being shown, and making sure they didn't get left behind by everyone else, as that would've meant immediate pain for them."

I think you are right. I do not believe the notion of a bailout was ever raised at board meetings. I think there was a mob mentality here. But I think part of the mob mentality is an implicit, unspoken understanding that not everyone will be held accountable. In a mob, people will exceed the speed limit en masse, they break windows, loot stores, burn cars, tear down goalposts... And deep down they know that the police cannot arrest everyone.

We can all see that this bailouts is necessary to prevent financial catastrophe--and there have been similar bailouts in the past. This is part of a pattern, Pombat. The financial sector has a blow-out party and in the morning, the rest of us have to pick up the pieces.

Let us be clear here: the financial markets are not in trouble because some folks over-extended themselves and now must default on their mortgages. The problem is that these mortgage instruments were consistently, deliberately, even criminally over-valued by Wall Street investors. Even loaning cash to a drug addict makes sense if you value the risk of non-repayment properly.

USwest said...

I see it as Pombat does because I am like Pombat. I've rented the same 1 bedroom apartment for 10 years. Granted, I haven't needed to move because of a growing family or anything like that. But I didn't have the financial ability to move, either.

I didn't move to a bigger place, although that would have been nice, because economically it made no sense. The imbalance between rents and mortgages was so great, it was much cheaper to rent and then to bank the difference if you could manage that.

I had a friend who bought last year. They had a good down payment and they think they will have their $535,000 (cheap by local standards) house paid off in 15 years. They did it the old fashioned way. However, at a certain point, she said, "Hell, I should just buy the biggest house I can. If I loose the house, it isn't my money. It's the bank's money." I don't think she was alone in that notion. In California, we see people just up and walk away from a house with no real consequence. They just stop paying, move to a rental and let the bank deal with it. And then the house sits there, mildewing, price still out of reach for people like me, who work off a monthly budget, to buy. So my sympathy is very limited. I'm paying for this and I did nothing to encourage it. This "correction" needed to happen. It hurts, but it was necessary.

Now, let's look at the 5 year number that RBR mentioned. Keep in mind that the negative amortized loans were set for a period of 5 years. Many of these poor little "victims" had a plan to buy what they could with an interest only loan. Then they would either re-finance or sell at an elevated price to get the home they "really" wanted. This is how mortgage deals sold these instruments. And it was based in the idea that prices wouldn't fall.

It wasn't just homebuyers, either. Many people took out lines of equity credit to renovate their homes, buy cars, go on big vacations, etc. And they did so under terms that made it impossible for them to pay down their new debt on existing assets. That is plan irresponsibility and bad decision making. No sympathy from me. Sorry.

I also want to point out that at the micro level, everyone was benefiting from this game. Little local mortgage dealers, real estate agents, contractors, insurance agents, etc. were making bank. And many newcomers entered that field thinking they could milk it. And I promise you that many were under-qualified and unscrupulous, often encouraging bidding wars between buyers to get bigger commissions. And people who would never have qualified for loans took loans they knew they couldn't afford and would never have been able to pay back forgetting the old adage that if it's too good to be true, it probably isn't true. I have a hard tome believing that so many of these people were that dumb.

It wasn't just big banks counting on bail outs. It was greed, pure uncontrolled, unadulterated greed from top to bottom. That is where the real moral hazard is.

Raised By Republicans said...

Well, everyone was benefiting as long as new money kept coming in. As soon as money stopped entering this little circus, the house of cards collapsed. It was a pyramid scheme (aka Ponzi scheme).

US West brings up a good point about the 5 year average and people planning to get out quickly but then got stuck when prices went up.

US West also brings up a good point about people taking out home equity loans to finance consumption (like vacations and cars) instead of investment. In effect, people were using their houses like giant low interest credit cards but then the interest rates started to get adjusted and whammo.

I'm not saying that irresponsible borrowers should absolutely be bailed out. But I am saying that they have every right to say "Hey, the fat cats on Wall Street were just as irresponsible as I was. Why do they get bailed out and I get a tax increase?"

The Law Talking Guy said...

Banks and mortgage brokers went around telling unsophisticated buyers that they needed to buy now and get in on the "ladder" or lose the possibility of ever having a house for their families. Combined with affordable rates based on all-time-low Fed interest rates, this was a very compelling argument by people who should have known better. The riskiness of the loans looks a lot more acceptable when you are weighing it against the fear that you will never have a house for your kids, that you will be a renter your whole life. And the peer and parental pressure: everyone else was buying houses and doing well, just as our parents' generation had done. While these factors did not motivate me so much (I was motivated by the mortgate interest deduction because of the high cost of rent and phase-out of other dedux in my tax brackets) they were powerful backgrounders to the decision to buy.

USWest and Pombat had a different personal situation than many of the recent homebuyers in two-earner couples with new young families. They made the right decision for themselves, but they also lacked some of the pressures that young families were under.

I did not take out a risky mortgage, except in the sense that it's a risk to owe so much every month. But I had the financial luxury to do so. If we had been living on half the income, it might have been a different story.

Pombat said...

RbR: "everyone was benefiting as long as new money kept coming in". NO. Those who already owned a house, as well as the banks and mortgage lenders, benefited as long as new money kept coming in. People such as USWest, Spotted H and myself, the sensible renters who realised we could not afford to buy yet, were NOT benefiting from all this. And the worst of it? We're now suffering from it, having not benefited at all during the good times!!!

Which brings me to your last para of that post - yes, the irresponsible borrowers have the right to bitch and moan about Wall St being bailed out whilst they, the borrowers, suffer. The people who were not irresponsible, who are stuck in rentals still, have even more right to moan about Wall St, in addition to the right to moan about the irresponsible borrowers who continued to supply the demand for overpriced houses, further pushing the price away from the reach of the renters.

LTG: yes, banks and mortgage lenders were encouraging people to get into the market asap, often by playing on fear, but I haven't seen any marauding gangs of lenders out on the streets, netting potential buyers and dragging them off to be convinced. Everyone I know who's been offered a risky mortgage was offered it after they voluntarily stepped foot into the bank to discuss a mortgage. Me? Well, I, like most other non-fatally-stupid people, knew the standard "you can get a mortgage of 3-4times your salary, and you need a deposit". I optimistically multiplied my salary by four, looked at house prices, then went to the pub to drown my sorrows and slightly reduce my available deposit. I did not go to the lender anyway, desperate to get any kind of mortgage, as I knew I would be ridiculously over-stretched, and it was a dumb idea. You don't have to be that smart to follow the same logic.

Ok, couple more points to address. The mobility issue. In the UK, you have a fair mix of people in terms of whether they're likely to move or not. Pretty much everyone moves to go to university, and often ends up starting their first job in a town other than where they grew up (although people who grew up in big towns often end up in them). Then, some move a lot, some stay put.

In Australia, I don't think people move around as much - there aren't as many decent sized towns, and moving from one to the other is a fair old hike: Melbourne's fairly central, and our closest other decent sized towns are over an hour's flight away.

But, linking to the point about couples with young families needing to buy - aren't young families less likely to want to move anyway, as they want to provide stability for their families? And if you are likely to want to move sometime soon, is buying a house really a sensible option anyway? The sales process can take a very long time, and you don't want to end up stuck between two cities, trying to sell one house that you've clearly vacated whilst also paying for your new one.

And my other response to LTG's point about USWest and myself having a different personal situation: Spotted H and I are a two earner couple. We'd like to own our own home. We'd like to own our own home before we end up with "pressures" such as a young family. But we haven't gone and greedily over-stretched ourselves. I have a counter-example as well: a couple we know here, who were pregnant with their third child before they bought. They recognised that they could not buy sooner, so they sucked it up and continued renting for a while. It's not what they wanted, it certainly wasn't ideal, but they dealt with it because they had to.

The Law Talking Guy said...

Pombat, I didn't mean to pry, but I don't believe you were in a two-earner situation with SH for most of the 2001-2006 runup in house prices. People who were renting witn young families at that time (not me) were subjected to the most pressure.

And they didn't take payments they couldn't afford. They took payments that might go up later if the market readjusted interest rates (which they were told was unlikely), if they could not refinance (which they were told they could), or if they could not sell the house (which they were told would definitely happen, for a profit). And it was happening just like that for people all around them.

USwest said...

What LTG writes about young families in his last paragraph above is true. I am single, but even I felt the pressure. But the problem with all of this discussion is that it is really hard to identify broad trends.

1) the housing market is very fragmented along regional lines, even within single states. Central California is much cheaper that along the coast.
2) the decision to purchase a home or to continue rent is very personal. It is based on economics, life situations, and personal desires and expectations.
3) So much or what we can discuss is anecdotal. There were so many people who got into the market between 2001 and 2007 (there were people jumping in as late as that)that it is hard to tell who were investors and who were first time home buyers. And that is why Congress has had a hard time figuring out how to help those now facing foreclosure. They don't want to bail out investors. Yet, as Obama pointed out in his Economics speech, when you file for bankruptcy you can write off the value of all houses but your primary residence. Huh???

I live in a very expensive market where investors love to buy their vacation homes. This community is going to suffer big time because all the residents are leaving. The young families that make communities thrive are going. That will have long term consequences for this city. And companies and government agencies will leave here because they cost of living is so high that it drives up the cost of labor.

The friends how bought last year lived in a rented 1 bedroom bungalow through two babies. They only bought when the second baby was a 6 months old and the first was 1 year and half. I thought they were nuts to have waited that long. It was so third world! But they pointed out that every month they rented for $950 a month was a month where they stashed another $1000 in the bank. To rent a very modest house would have ran them $2500 month.

So while I am angry, like Pombat, I am also pleased because unlike a lot of these poor folks, I have no worries.

What I want to see happen is for old fashion, interest bearing savings accounts come back into vogue. I don't want fancy financial instruments. I want to do what middle class people do, what my parents did, . . . work, save, and earn their homes. I think that is where we are headed.

The Law Talking Guy said...

What I wonder about, USWest, is whether a return to more simple financing will end the multiplier effect of loans and financial instruments, causing a dramatic economic slowdown. Also, such interest-bearing accounts only work when there is almost no inflation, which is probably never going to happen again. So while I see the attraction, I just don't know if we can "go back" to any point in time.

My parents did work and save, true, but the value of their house skyrocketed in the 1980s (through no fault of their own) and their low (3-5%) fixed-rate mortgages were minced by the Great Inflation of the late 1970s, early 1980s. So they didn't just work and save, they got lucky and got handed tons of home equity. We can't expect to reproduce that good fortune.

USwest said...

Yeah, probably true.

But I feel like so much of this is over my head, as my parents did. They didn't make their first investments until the late 1980's, just when that was coming into vogue.

I have investments, but it doesn't seem that you can "make" money anymore unless you take big risks or get a big hunk of cash from somewhere, seed money. And that is a very dangerous trend because it fosters an environement where risky behavior is encouraged while good old hard work is undervalued and under-rewarded. If that continues, then we will just go from bubble to bubble.