So much for that mantra of former top executives at failed financial giants that there was no way to see the storm coming …

Many thanks to Rich over at Piggington’s for helping us dig this two-year-old piece out of the Doom files.  It was first posted as The Safety Net that Never Was – Part X (Oct 2, 2006).  Rich was kind enough to call it "prescient," and after rereading the article I’ve got to admit the old crystal ball seems to have been having a good day.  Squint a bit and parts might even read a bit like testimony to the Congressional committees that are presently assigning blame for the meltdown.

Even the comments to the original post were fun to reread, sort of like looking at the ads in a dusty VHS tape recording of Star Trek TNG.  It’s good to remember that Doom has always depended critically on the the insight of you, our readers and commenters.

 

MORAL HAZARD AND MBS

(first posted October 2, 2006)

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). [UPDATE: as of 08 Oct 08 the Daily Reckoning appears to have a slightly different 15 Sep 06 version here.]

[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 14:00:05

The 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 market 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."