MORAL HAZARD AND MBS
Mortgage finance is conceptually simple. A saver lends money to a homeowner so he can buy a house. He then pays her back in installments, principal and interest, until the loan is extinguished. These flows of money were traditionally piped back and forth between savers and homeowners by local savings banks, or thrifts, designed for the purpose. Over the years, however, the "plumbing" to convey these flows has evolved into a nightmarish Rube Goldberg machine of securities, derivative instruments, vehicles, and intermediary markets.
Moral hazard neatly encapsulates one thing that can go wrong with this complex system. People may try to to over-exploit the money-flows, thinking that "just a little more" can’t hurt when the amounts are so enormous. Furthermore, they likely think any damage will ultimately be made good by something like insurance or a government bailout. Let’s have a look at where these attitudes might lead now that the historic housing bubble has burst.
The manager and employees of a local thrift would know exactly what was at stake with the bank’s savings accounts serving its mortgage customers and vis versa.[1] Today, some parts of the mortgage finance system are very remote from the savers and homeowners they serve. Those involved must often doubt that the money flashing through their computer screens concerns anything real. In that case the operators must be tempted to extract just a few more pennies from the "pipe" they are managing. In a Daily Reckoning story [2] earlier this month Dan Amoss captures some of the problem of this remoteness.
"Two additional factors that the cheerleaders of the mortgage-backed security market ignore and minimise are human error in the pricing of risk and moral hazard. Monte Carlo simulation models and supercomputers cannot fully distil raw human emotion into neat formulas and pretty bell curves. Misunderstanding the risks involved with financing a home purchase on the other side of the world can lead to an abrupt liquidity crisis when the momentum behind the housing market stalls, as it has now."
Indeed there is also the problem of the gaping separation between the two end users in the system. The East Asian saver [3] has no clue to what speculative uses her money may be put, like using home appreciation as a "personal carry trade"[4] vehicle. At the other side of the system, the local lender can lose focus if the risk of his lending transaction immediately transfers off his shoulders.[5]
There are also problems with large macro players in the mortgage market. AEI’s Peter Wallison has pointed out [6] that the big GSEs are largely unconstrained because the implicit guarantee removes the risk necessary for market discipline. New York Fed President Timothy Geithner feels [7] that hedge funds’ investors are too removed from risk, so that market discipline needs to be replaced by regulation.
Finally, from Nobel Prize winning economist Kenneth Arrow, we have a fundamentally different approach. Arrow argues [8] that moral hazard can be confronted with morality (who knew!)
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Notes and References
[1]: Even at this level, the plumbing is self-sustaining because it is paid for by extracting a small portion of the money it’s passing around. To further mix metaphors it’s a bit like a medieval miller taking payment in part of the flour he grinds from the grain.
[2]: "Figuring out Fannie: Fannie Mae, the US mortgage-lending giant, is a hard nut to crack. And as US housing market worsens, a disconnect is growing between those who underwrite mortgages and those who end up holding them", by Dan Amoss, Daily Reckoning (UK), September 13, 2006 (revision posted Sept. 20).
[3]: Much of the money for US home mortgages comes ultimately from the Japanese Post Office Service, the world’s largest bank.
[4]: "Deflation Delayed Is Not Deflation Denied", by David Chuhran, Gold Eagle (obviously gold-bugs) blog, August 6, 2006.
"Since all money is loaned into existence, it stands to reason that a portion of that newly created money will find its way into demand or checkable deposits. Much of our post-bubble recovery has relied on consumers tapping into their home equity through loans or refinances. Those loans were deposited and then used for everything from big screen televisions to jet ski’s, but I also believe a significant portion was used in a ‘personal carry trade’ where people invested their borrowed home equity money in the stock market."
[5]:Comment to ‘The Guiding Principle Of Mortgage Lending’, by "Peter T" The Housing Bubble Blog, September 27, 2006.
"Comment by Peter T
2006-09-27 14:00:05The problem of too high appraisals seems due to separation of responsibility and risk. If the people who decide about the loan carry the risk of it failing (like an old-fashioned bank), the market would correct it itself by punishing takers of too high risk. The state might regulate this by reducing the separation of risk and responsibility, but should not crack down on appraisers that were under pressure from brokers (except for going after the brokers)."
[6]: "Moral Hazard on Steroids: The OFHEO Report Shows that Regulation Cannot Protect U.S. Taxpayers", by Peter J. Wallison, June 23, 2006.
"But Fannie and Freddie are different from banks in one important way: despite the fact that their securities explicitly state that they are not backed by the federal government, their government charter and mission–plus the government’s past behavior–have persuaded investors that neither company will be allowed to default. Thus, in a very practical sense, all their debt obligations–not just some limited amount corresponding to a bank’s deposits–are seen by U.S. and foreign investors as nearly risk-free, and therefore are not subject to market discipline."
[7]: "NY Fed chief warns on hedge funds", by David Wighton and Peter Thal Larsen, MSNBC, September 21, 2006.
[8]: "The Economy of Trust", by Kenneth Arrow, Religion & Liberty, Summer 2006.
"The market has deficiencies of a kind for which ethics is a remedy. For example, the world is really filled with private information. There is inside information on products and in contracts. In these situations, there is a very strong possibility of one person using this information to take advantage of the other. If this happens frequently, a market may not exist at all because the buyers know that they don’t know certain things, and that the sellers can exploit them. Therefore, it’s not so much that there are potential unfair gains, but that such uncertainties about private information can make the market inefficient. In fact, if the problem is pronounced, the mark
et may not exist at all. This is a situation that is studied particularly in insurance contracts; when the person insured may have private information about dangers unknown to the insurer, there is said to be “moral hazard” or ‘adverse selection,’ phrases in the last forty years that have been imported into economic analysis from insurance literature.There are various ways of handling these cases. One of them is the existence of morality. It turns out that to a considerable extent, people spontaneously do avoid taking excessive advantage of their inside information, their private information. Part of it is an understanding that even though I would gain by cheating, it would bring down the market if everybody did it. Of course, there can be a problem if one person says, ‘Well, if I did it, nobody will notice.’ But then, if each person feels the same way the whole thing breaks down. Part of this behavior, though, is morality—the person doesn’t cheat because he thinks it’s the wrong thing to do. To get markets that work, you have to keep the other person from trying to cheat you at every moment. So morality is closely related to the workings of the market."
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This is one of the reasons I have become a huge proponent of not allowing banks to resell mortgages for at least a year. We are reading more and more where loans are going into foreclosure, never having made a single payment. Mortgages are sold off before banks run the risk of facing the consequences.
When you want to achieve moral and ethical behavior from corporations, quite frankly, nothing motivates like self interest. When the consequences of bad loans rest squarely on the lender who made the loan, lenders will start issuing, and strictly following, their own “guidance.”
Here’s some evidence [9] for Chuhran’s “personal carry trade” theory ([4] above) from none other than Freddie Mac Chief Economist Frank E. Nothaft. Hat tip to commenter John Fontain at today’s Ben’s Bits Bucket.
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[9]: CNN OPEN HOUSE: The Bursting Bubble; Trips That Can Change Your Life; Preparing Your Garden for Spring, Aired September 30, 2006 – 09:31 ET, CNN rush transcript. Emphasis is mine.
Twist, while I respect your far greater knowledge in the area and your judgement I wonder how defering liquidity really does much to help since bad lending practices will obviously result in heavier discounting of the mortgage backed securities anyway, leading to the same financial result for the lender(albiet discounted to present value)without the ban. A truly awful lender will find their mortgages increasingly unmarketable. Is the problem more basic and individual, involving the rejection of incentive compensation to broker/employees elevating “the deal” over responsible lending practices or as simple as strict enforcement of criminal sanctions against mortage faud applicants (ask FEMA about that sort of thing). Government bans of business practices can have all sorts of perverse and unintended consequences. While the ban on “redlining” was well intended, it is fair to conclude that many primary lenders now are forced to do business in areas of very high risk without explicit commensurate reward. That high risk may only acutally be first measured and mitigated(some would say subsidized) in a portfolio sold to the secondary markets. Absent that risk spreading avenue do lending branches near those high risk areas close, and we now need a new policy to require that high risk branches remain open?Political correctness driven regulatory policies may actually have promoted marginal and even questionable lending in pursuit of home affordability. I fear the problem is far more complex than John’s “over-exploited” money flows argument suggests.There is not always an immoral greedy capitalist behind every problem. And why is it that the quasi-government “IES” are in the mortgage business anyway?
Mike-
Thank you for a marvelous comment. I’m not an expert in the world of finance- my obsession is tracking supply and demand. You are absolutely right though,it is difficult for intervention to be forward thinking- and not only in the world of finance. (Ask any Southerner about how well kudzu worked out for erosion control!)
The ban on redlining may also have additional unwanted consequences. Most of the new foreclosures seem to be coming from more marginal buyers. These exotic loans will probaby end up hurting disproportionately the people they were supposed to assist.
Don’t you think though, that the redline banning so far has not hurt lending institutions- that they have found the subprime market to be lucrative? Certainly the exotic products remain heavily promoted.
In addition, while a lot of the risk may come from lower income marginal buyers, there are now even more marginal buyers- those folks who took advantage of these products to buy homes beyond their means. Lenders so far seem to feel the rewards worth the risk.
I think what is fairly undisputed is that lowering lending standards has increased risk. Insurance companies and credit card companies can make money in high risk markets- they charge more for higher risk products- mortgage lenders do the same- so tightening standards won’t necessarily close down subprime markets.
So what do we do? Do we just let all the bad loans migrate to the lowest point, and figure Uncle Same will be the bag holder? Do we try and keep them out of the system? Do we want to impose all kinds of restrictions on lenders? Do we try to rig the system so that minimizing risk is in their own best interest? Does the government decide that it’s willing to genuinely guarantee a certain amount of risk in the interest of assisting the truly needy, but F&F are bloated and not doing the job?
I like the idea of keeping the first year risk with the originating lender, but as you say, this carry’s it’s own risks.
I appreciate your insight- I’m glad we’ve got you around to keep John and me on our toes!
Twist, thanks for the kind words. At some point I guess a “first do no harm rule” applies to my view of government intervention. Any explicit bail out of bad loans or bad lenders is awful policy that merely enables the irresponsible behaviors at both ends. That sort of largess does seem to be in vogue however. It tends to make government larger you see and it sounds so caring. Whether sub-prime home lending is profitable on a stand alone basis has yet to be answered but in many areas where pay day loan and pawn shops far outnumber legitimate banks a few hundred basis points may well not cover the risks, not only of borrower default rates but also underlying collateral value risks. Regardless, like insurance fraud and other such problems,the existance of mortage fraud and even simple default always costs the responsible consumer more. Even if, as some masters of oversimplification might suggest, we could “shift” responsibilty to the “shareholders”…thats a shell game, the costs will be internalized and responsible consumers will pay. You cannot conscript capital no matter how much some may wish to. When you are in a “risk pool” with people who cheat or just do not pay, the costs for the pool go up. Ultimately allowing people to choose to live beyond their incomes is either a hollow promise or a forced transfer of wealth from the rest of us. I’ll take the first one every time. When government “promotes” alot of things…homeownership or art for example…it seems to get worse and more expensive.
Mike & twist -
I think this one [1] may have been found by Jan-Martin. In any case maybe he can help with the German. The paragraph quoted suggests why investors are greedy for risk, and how this could get them in trouble.
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[1]: “In Europa wächst der ökonomische Nationalismus”, interview with Stephen Roach, Handelsblatt, Montag, 2. Oktober 2006, 10:47 Uhr.
John,good to hear from you on this. All due deference to our German friends and the rich Belgian dentist bond buyers,”yield hungry investors” by definition are probably not in “secure investments.” As external demographic and other (non-Beta) risks ebb and flow, they may or may not have “properly” evaluate risk and reward, thats what makes a market. Only the final opinion from the firm of Short, Brutish & Nasty can answer whether they have lulled themselves into false security, and again, their opinions and expectations don’t matter economically, only their actions and the results. And John,please note that “mortgage-backed securities” are NOT among the risky investment options in the above quote. As far as unfunded pension liabilities see the “hollow promise” option in comment 5.
Mike -
I believe the Amaranth meltdown a couple of weeks ago took out a good chunk of the pension money for the municipal workers at the City of San Diego. With bonds so high (and therefore yields so low) the pension and insurance industries have been forced to embrace risk just to meet their obligations. As far as MBS not being in the classes cited by Roach, I believe the paper deriving from especially the Alt-A/sub-par market has been sliced and diced so many ways it’s hard to tell just where it’s gotten itself to.
My word, what was a public employee pension fund(even in California) doing in a commodity hedge fund? Sounds like trustee liability question to me, but what do I know. Embracing risk for a pension fund is growth stocks, not private commodity hedge funds. I think you mentioned in a prior post that MBS by WaMu got a AA rating, remember the “implicit guarantee” discussion? Clearly NOT JUNK. Now Ford, thats junk.
Greetings from Chicago,
I came across this site while I was reading some articles about the housing bubble. I am not a real estate expert by any stretch of the imagination but sometimes common sense and history is all you need. I am really starting to see the effects in my neighborhood. We have 3 for sale on our block, one being in foreclosure. The 2 other houses have been up for sale for almost a year, both have dropped their price twice and neither have had anybody even look at the house in the past month. there is now a fourth house that doesn’t have a sign in front of it but acording to domania.com it is in pre-foreclosure. I live in a very nice mid to upscale neighborhood where 2 years ago, homes were selling within a couple of weeks.
I’ve been in my house for 5 years and have loved seeing the price skyrocket over the last 5 years but common sense tells me that over the next 5 years, the price will probably be about the same as it is now. Thank g*d I don’t have any plans to move.
Boner-
Welcome- we don’t hear enough from Chicago- I’m glad you stopped by. Around here not being a real estate “expert” is considered a good thing. Too often “expert” means “vested interest in whitewashing things”- so we revel in our amateur status.
It sounds like Chicago is slower than these experts would have us believe:
http://realtytimes.com/rtmcrloc/Illinois~Chicago
We look forward to hearing from you again!
John, two things appear from the record dow close just now. First, after a large asset bubble it can take a very long time to get back to where you started. Second, despite the predictions of the gold lunatics, those who invest only in the 3 A’s (ammunition, antibiotics and agricultuiral land), and various other odd doomsayers we sometimes see quoted in the footnotes & margins, the now very obvious problems in the US housing market do not appear to be causing the sky to fall yet. By the way, WaMu(“WA”) is still above 40.
Mike -
Thanks for the tip on the Dow peaking, I hadn’t been paying attention (believe it or not, I do have a life up here). There are a couple of items on the sidebar now. If you think back a bit, you’ll see how Karl Rove engineered this little October Surprise for the GOP. Just four weeks ago, it was announced [1] that deep drilling in the Gulf of Mexico might(?) / would(?) / already(?) increase US energy reserves by a half. A week after everyone swallowed that howler, Aramco President Abdallah Jum’ah asserted [2] that Arabia could maintain current oil production levels for 140 years. Nobody in the MSM challenged this codswallop, it was as if Matthew Simmons had never lived (if I happen to get a chance tomorrow, I’ll ask him if there’s anything real there). These two Arabian Nights fairy tales rapidly faded away (in particular, the Jum’ah piece appears to be available only from Google cache now), but it left an aftertaste in the form of rapidly eroding energy prices.
This move against all reason and fundamentals is likely what caused Amaranth to be caught long on natural gas, dropping $6b, most of its investors’ capital. The MSM declared a peaking commodities “bubble” and gasoline prices eased. That would be the main reason the Dow Jones average went nuts [3] and finally hit a record today. All this smoke will dissipate shortly after the US election day on November 7th, but alas too late for the Amaranth investors.
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[1]: “Vast Oil Pool Tapped in Gulf of Mexico – Oil Pool Tapped in Gulf of Mexico Could Boost U.S. Reserves by 50 Percent”, by Brad Foss, Associated Press, September 5, 2006.
[2]: “Saudi says world has lots of crude left – But Exxon Mobil chairman predicts 50% demand gain over next decade” (Google cache), by William J. Kole, Associated Press, September 13, 2006.
[3]: “How great Dow art”, editorial, USA Today, September 29, 2006.
John, That Karl, he always was a clever guy. Busy too. I think I’ll go lock my door now. Maybe its time to reline the old cap with a bit more foil! I’m really glad you are known for your sense of humor or we would have to send the mothership after you , “up there”, since you can obviously read the secret signals and now know “reason and fundamentals”. But seriously, without all the oil evasion and zany political theater, a major housing bust in the US is now a known fact(albiet the magnitude is still somewhat being debated). ALL acedemic and most historic evidence suggests that fact would NOW BE FULLY INTERNALIZED by the market. Despite completely meaningless prol. opinion, investors and their models are not all stupid, and very few are just inveterate gamblers like your boy at Amaranth, so where is the DOOM? Are you now predicting Act 1 in November? Will this be like all such apocalyptic predictions and in November slid further into the mist? Will I ever remember how to spell?
John, PS I am sure will like the lead story in last week’s The Economist, “The dark side of debt”(9/23/06)
OK, Mike, you win this round (don’t start getting cocky!).
Mr. Simmons doesn’t seem to think the recent drop in oil prices has to do with the election at all. In fact, yesterday he and some other investor types like T. Boone Pickens were putting their heads together in an exercise very much like ours trying to get a handle on what’s going on. Whatever they came up with, Simmons now feels he has a better handle on what’s happening than before.
He was kind enough to share with me some good insight into the two stories cited above. The AP picked up Jum’ah speaking at a conference last month in Vienna, where all the OPEC guys were basically rehashing there old “proven reserve” numbers from a generation ago when those numbers were being used to set/negotiate production quotas. In other words, that 140 years was just noise. Simmons dealt with the Chevron Gulf find at length before and during his prepared talk. Chevron has not been able to spend nearly enough time establishing the parameters for “Jack 2″(?) Yes there is potential, but it is very potential potential and we are years away from knowing if it will pan out. And even if it does, there is a real problem with getting the rigs to exploit it (Simmons details in his slide deck the enormous logistical challenges renewing the world’s fleet of rigs).
He also suggested that a big factor in gasoline volatililty is the ongoing conversion of US gasoline markets from RFG to RBOB(?) standards. He said that presently there are two parallel production chains, the old and new, and the market blips are a result of this complex conversion. (Perhaps this is like the painful conversion from English to Metric in Canada many years ago, when food prices and such bounced around for a while.) Again, no political plot, just market overreaction to the natural problems that always accompany such an exercise.
Two takeaways from the talk: as an investment banker and life-long Republican, Simmons states flat out that “Free markets will not solve this problem” (the consequences of Peak Oil). The other was that just in the last couple of weeks, looking back at world-wide production reports, he has nailed the Hubbert Peak for world production at December 2005.
Sorry about the long OT, I’ve got to get something up on the new Fitch model before twist has my hide