Monday, October 20, 2008

Incentives and bubble logic

Question: Were bankers and risk managers and investors who got us into this credit crisis plain stupid? Or were they just responding to incentives up and down the line?

Answer: Both. For many people, it was rational to participate in the mortgage bubble even if they thought it might (would) end in tears. On the other hand, even smart people can be taken in by bubble logic if everyone around them is convinced. For example, here is a 2006 discussion from Brad DeLong's blog of a column by Paul Krugman, making the case that most of the country was not experiencing a bubble, and that zoning was the main culprit for coastal price increases (hence prices were sustainable). If you were a CDO modeler in 2006 and believed that argument, you might not have even considered that your model assumptions were way too optimistic -- even with people like Robert Shiller (and me) shouting that we were in the midst of a gigantic bubble.

Some of the best journalistic coverage I have found of the mortgage bubble is from Ira Glass and This American Life (audio, pdf transcript). They get the "local color" right from top to bottom: self-interested individual borrowers, local mortgage brokers rushing to assemble as many loans as possible, to be sold to Wall Street banks and repackaged as CDOs, rated by agencies like Moody's and S&P that were making record profits from fees, and sold to investors chasing yield in the midst of a liquidity glut caused by low interest rates. From their coverage you can see the incentives were messed up from top to bottom, and that many individuals anticipated trouble ahead, but couldn't put up a fight without risking their careers or bonuses. Some excerpts below.

borrower: ...I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. ...Nobody came and told me a lie: just close your eyes and the problem will go away. That's wasn’t the situation. I needed the money. I'm not trying to absolve myself of anything. I thought I could do this and get out of it within 6 to 9 months. The 6 to 9 month plan didn’t work so I’m stuck.

mortgage broker was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually produce. That was our difficult task, was trying to produce enough. They would call and ask “Do you have any more fixed rate? What have you got? What’s coming?” From our standpoint it's like, there's a guy out there with a lot of money. We gotta find a way to be his sole provider of bonds to fill his appetite. And his appetite’s massive. boss was in the business for 25 years. He hated those loans. He hated them and used to rant and say, “It makes me sick to my stomach the kind of loans that we do.” He fought the owners and sales force tooth and neck about these guidelines. He got same answer. Nope, other people are offering it. We're going to offer them too. We’re going to get more market share this way. House prices are booming, everything’s gonna be good. And ... the company was just rolling in the cash. The owners and the production staff were just raking it in.

Wall St. banker ...No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.

...All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad. If I’m an investor buying that, if I get a little bit of return, I’m fine.

CDO packager: ... In 2005, we had an internal debate here because there were two banks coming to us, why don’t you do a deal with us, BBB securities, you get paid a million bucks in management fees per year. Very clear, just like that, in 2005. And we declined those deals. We just don't believe those BBB RMBS assets are money-good. And we thought if we do a CDO of those, that's gonna blow up completely. We were early in '05 by not wanting to do those deals. People were laughing at us. Saying you're crazy. You’re hurting your business. Why don’t you want to make ... Per deal, you could make a million dollars a year.


Anonymous said...

Anna Schwartz: "Everything works much better when wrong decisions are punished and good decisions make you rich."

From an account of a recent interview in the Wall Street Journal, via Brad DeLong.

Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."

Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake.

Ms. Schwartz doesn't buy it. "It's very easy when you're a market participant," she notes with a smile, "to claim that you shouldn't shut down a firm that's in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that's their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves. The [government] doesn't have to save them, just as it didn't save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on."

It takes real guts to let a large, powerful institution go down. But the alternative -- the current credit freeze -- is worse, Ms. Schwartz argues.

I guess the lesson that some will draw---indeed, have drawn---from this is that if you want to run big risks to make big money, make sure you take lots of hostages, or to put it another way, that lots of other people are put at risk without realizing it (until it's too late).

... "Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on."

Of course, to the most cynical beneficiaries of this debacle, ordinary people are just another class of chumps, who were dumb enough to deposit cash in banks and participate in IRAs and 401(k) plans:

"As for them, the more innocent they are, the more they deserve to be shot."
-- Bertolt Brecht, to Sidney Hook

Quoting Aaron C. Brown in an Amazon reader review of Richard Bookstaber's A Demon of our Own Design:

Despite being a very smart guy with a quarter century of experience in cutting-edge trading, Bookstaber cannot overcome the disadvantages of being trained as an economist, especially an MIT economist. In the final analysis, he believes risk is bad. Trading is defended as socially useful when it provides liquidity, when traders exploit pricing discrepancies caused by short-term supply and demand forces. These traders stabilize the market. But at least half of trading is trend-following, which exacerbates pricing discrepancies and sucks up liquidity, destabilizing the market. To a University of Chicago finance guy, these are symmetrical market forces, both good. Bookstaber correctly points out how financially-supplied liquidity ushered in the Industrial Revolution by converting frozen wealth to dynamic capital. But he doesn't mention the momentum traders who forced prices quickly to their eventual equilibrium, sweeping aside those who try to stand in the way of progress. This is the creative destruction of capitalism. Economists are comfortable with the markets facilitating real economic decisions, spreading the inherent risk among willing investors. They are less comfortable with the market forcing real economic decisions, creating virtual risk and imposing it upon unwilling actors.

That's us folks, who just want to support our families, save enough for our retirement, and live a decent and comfortable life.

[To her credit, Ms Schwartz makes it clear that in her opinion the Fed should have taken steps to moderate the housing bubble. Of course, I don't know why Alan Greenspan should have bothered with that, when all those self-styled Objectivists were out there making a killing off their hapless inferiors.]

Anonymous said...

PS: A bit more on Brecht, from a comment on a review of a performance of The Threepenny Opera:

Nik Smythe ends his review with “It's arguable Brecht was always aiming for a non-plussed response to his work, perhaps to illustrate the fatuousness of the convention of theatre itself.”

There is a growing body of evidence to suggest that Brecht preferred a ‘non-plussed response’ because the alternative was being rumbled as a conman and fraudster who exploited all those around him, who hid behind a cleverly constructed fa├žade of ‘genius’ which far too many people who should know better are still helping to keep in place; and whose convictions were limited to the overwhelming importance of filling his Swiss bank accounts.

Consider the following anecdote from a recent Michael Billington review:-

‘The American socialist Sidney Hook put the case for indifference best after Brecht came to dinner in Manhattan in the mid-Thirties. Stalin was forcing thousands of Soviet communists to confess to fantastic crimes, and Hook asked Brecht what he thought of the show trials. '

It was at this point that he said in words I have never forgotten, "As for them, the more innocent they are, the more they deserve to be shot." I was so taken aback that I thought I had misheard him.

'"What are you saying?" I asked.

'He calmly repeated, "The more innocent they are, the more they deserve to be shot."

'I was stunned by his words. "Why? Why?" I exclaimed.

All he did was smile at me in a nervous sort of way. I got up, went into the next room, and fetched his hat and coat.

When I returned, he was still sitting in his chair, holding a drink in his hand. When he saw me with his hat and coat, he looked surprised. He put his glass down, rose, and with a sickly smile took his hat and coat and left. Neither of us said a word. I never saw him again.'

I bet he didn’t. Sidney was supposed to be enchanted by the dazzling complexity of the master's response, and to spend the rest of his life trying to untangle its deeper meanings; not call Brecht’s bluff. I suggest Nik call his bluff too.

Sidney Hook included this anecdote in his autobigraphy Out of Step, which I first read many years ago.

Anonymous said...

PS (2): I meant to include a link to that review (plus reader comments) in my previous comment on this post.

Anonymous said...

This discussion misses the point. All the examples are of people who had personal incentives for short-term profit but no effect on whole institutions. The borrower, in particular, had reason to think that price appreciation would bail him out. The middlemen had the positive incentive of making money that some other middleman would have made if they had been straight arrows.

But the CEO's and Vice-Presidents effectively looted their companies and walked off with the proceeds, knowing they were leaving sinking ships.

If I ever get my copy of Kindleberger back, I'll have to see if he makes this distinction.

Anonymous said...


The discussion does not miss the point. The post was about the internal logic of a bubble, which makes a mockery of Anna Schwartz's remark: "Everything works much better when wrong decisions are punished and good decisions make you rich."

Certainly the upper echelons of these companies looted them and walked away with the proceeds. That was the logic of the bubble from their point of view. All the bit players---the employees of the mortgage lenders, the borrowers, etc---had their own short-term incentives to profit from (or to try profiting from) the bubble. Collectively they all had an "effect on whole institutions".

The smart (and amoral) players at many levels undoubtedly saw where it was all headed, conserved their winnings, and jumped ship at more or less the right time (for them). Certainly the people at the top had the sweetest deal, because they didn't have to worry much about timing; they were going to make out nicely even if they got fired and had their names dragged through the mud by the "little people".

The unfettered free market inevitably moves in this direction. The powerful players will rig the game in their favor; that includes planting their acolytes in whatever governmental positions of authority are useful, cajoling corporate boards into giving them the huge compensation and severance packages, etc, creating and promulgating recklessly complicated and opaque investment instruments---whatever it takes, because after all, "good decisions make you rich".

Anonymous said...

What do you think of Daniel Davies' claim that it's not at all the banks' fault, but rather solely the central bank's?

Steve Hsu said...

Davies points out some macroeconomic drivers behind the bubble. I agree that a liquidity glut, savings glut, etc. were the macroscopic drivers.

He seems to think the housing price bubble was rational. On that I disagree -- he wants to use the rental yield vs bond yield metric for valuing homes, which I think is nuts. We had record low rates due to a *temporary* liquidity glut.

Most importantly (and this point is made right away by comment #10 on the thread), the fact that the collapse of the bubble led to a (near?) collapse of the financial system depends on many details (leverage, CDS, CDO, derivatives) that might have been moderated by better regulation or incentive structures.

Anonymous said...

All this talk of stupid bankers (and humanity in general) makes Eric Idle's Galaxy Song seem rather apropos.

Anonymous said...

More great coverage from the NPR/TAL team of Alex Blumberg and Adam Davidson:

How Credit Default Swaps Spread Financial Rot

Unregulated Credit Default Swaps Led to Weakness

From a comment on the first story:

This is nothing more than "Springtime for Hitler" writ large. And at least in The Producers there is a moment when Leo Blum realizes that they will never be able to pay people back if the scheme goes bad. Here, one senses that nobody ever had that realization until after the dominos started falling.

Also see another commenter's nicely presented analogy to bookmaking.

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