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Friday, October 3, 2008

Challenging assumptions about the financial crisis

This started out as a quick response to Jim's comment on a previous post but it started getting long and I decided I'd just make it a full post (and to give fair warning, it's quite a big longer than usual).

First, a mini-econ lesson for anyone who hasn't taken econ in a while: "moral hazard" arises when people do not face the full costs or benefits of their actions and end up acting in disagreeable ways (that is, disagreeable to the people who DO face the full costs). The most common example is when people do not face the full costs of risky action (like because of insurance) and thus take more risks than they otherwise would. As I stress to my students, the name notwithstanding, moral hazard does not necessarily mean people are acting unethically (though it may) - it does mean they are responding to the incentives they face. The other important thing to know is that economists typically do not attach judgment when they see people acting in self-interested ways (and as I also stress to my students, self-interested is not the same thing as selfish). That doesn't mean that, as a human being, I don't frown on people acting like jerks, and I'm not talking about fraud or other illegal activity, but I generally fully expect people to act in their own self interest.

Let me also say loud and clear that my understanding of the whole financial situation is pretty tenuous and this is not my area of expertise at all. But the way I see it is that there are a lot of layers - you've got commercial banks making loans (mortgages) to homebuyers, and then selling those mortgage contracts to investment banks, who bought them with money from various investors, who bought insurance for those purchases from companies like AIG. So moral hazard problem #1 is that the people making the loans (commercial banks) were never going to be on the hook if the homebuyers defaulted. This presumably led them to make riskier loans than they otherwise would have. Moral hazard problem #2 is that since investors were insured, they had less incentive to monitor what the investment banks were doing with their money and the investment banks had less to worry about if the mortgage-backed investments ended up being crap. This presumably led them to hold more of these risky assets than they otherwise would have. Then throw in that when the mortgages were sold to the investment banks, they were packaged in such a way that it wasn't easy to assess their true value (since some 'good' loans were grouped with some 'not so good' loans in order to mitigate risk), and especially hard once the housing market started to tank. And as I understand it, the big problem now (and the main focus of the bailout) is that we've gotten to a point where no one knows which mortgage-backed securities are OK and which are crap so they don't want to buy any of them, even the good ones. That means their value to the banks holding them is essentially zero (i.e., if you can't sell an asset when you want to, it basically becomes worthless to you).

OK, so that's all preamble. Jim's comment was: While I agree that the average home buyer shares some culpability, I find it disingenuous to imply that a banker, presumably educated, experienced, and well paid, whose life's work it is to know how to assess and manage risk, should be compared to the average home buyer, who trusts his broker and the system to provide reliable information and recommendations.

I don't necessarily disagree with Jim but there are some assumptions embedded in what he wrote that I think are important to point out - namely, the assumption that the "average banker" should have known better than to take such risks but that the "average homeowner" didn't understand the risks he/she was taking. This seems to be a pretty common assumption, and it may even be accurate, but my guess is that those making this assumption don't actually know if it's right or not. That is, many people seem to assume that the majority of the risky mortgages were issued to 'deserving' homebuyers - their credit might have been terrible or their income shaky or they simply were in over their heads but since the bank/broker told them they could afford it, who were they to disagree? At the same time, many people seem to assume that the majority of the bankers were greedily buying up too many of these crap mortgage-backed securities, knowing that they were crap.

But what about the homebuyers who knew they were accepting a risky mortgage (for example, people who fully planned to re-finance or flip the house)? Are they any less to blame than the greedy bankers? And what about the 'honest' bankers who saw these mortgages as risky assets but believed they were fairly valued (i.e., the price and return reflected the risk)? Or the ones who are holding securities that are probably OK (i.e., not backed by crap mortgages) but no one will buy them simply because everyone is panicked? Are these bankers any more to blame than the deserving homebuyers?

I think most people are willing to believe that there are some greedy
folks among the homeowners and some honest folks among the bankers but I'd wager that no one knows for sure what the proportions are in either group. To be honest, as a fairly liberal idealist, I'm certainly inclined to believe there are many homeowners honestly got screwed. But I'm also hesitant to assume that there was a lot of overt fraud going on, and an economist, I've been trained to be super-conscious of what assumptions or biases might be underlying any analysis. So my point is that I simply wonder why so many people believe that among homebuyers with bad mortgages, the deserving homebuyers dominate the informed homebuyers, but we believe that among bankers, the greedy bankers dominate the honest bankers? If anyone has data on the actual numbers, I would love to see them. And if I'm over-simplifying this to the point of being totally inaccurate, feel free to tell me!

UPDATE: In case this wasn't long enough, the San Jose Mercury News has a nice little article about the risk-taking that was going on at each of the levels, starting with the homebuyers and on up to the investors.


  1. I love this post because it makes your thinking, the way an economist thinks, transparent and accessible.
    Isn't that part of what we strive for when we teach something, that learners learn how to think the way the experts think?

    I'm working on a couple of posts about learning over at my blog.

  2. This comment has been removed by a blog administrator.

  3. I noticed that there is no mention of the Federal Reserve system, without which there would not have been all the darn money creation post 9/11 that led to the easy money in the first place. Inflation and artificial interest rates are government creations my friends. So is The impending Great Depression II, mostly because of the FDR mentality of the mass of American people. The same government and policies that have vitiated the economy will only be ramped up as people beg for even more statism.


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