The Sub-Prime Fiasco and The Prisoners' Dilemma
Many factors led to "the perfect storm," causing the Great Recession. The sub-prime mortgage fiasco was the pin that pricked the housing bubble, setting off the recession. The perverse incentives of the Prisoners' Dilemma (Times column of Oct. 21) illustrate the process leading up to this fiasco.
For decades, the business of buying and selling homes was relatively simple, involving realtors, buyers, and lending institutions that examined a buyer's ability to pay and required a substantial down payment. During the 1990s, new types of mortgages such as adjustable rate mortgages and interest only mortgages, along with new entrants into the mortgage-writing industry, led to deterioration of lending standards.
Steadily rising housing prices, lax credit standards enabling newly eligible buyers, and more competitors in the mortgage writing business combined to drive up housing prices, a trend which fed upon itself. As long as housing prices were believed to escalate skyward, even the interest-only mortgage seemed no problem to either buyer or lender.
Firms such as Countrywide Financial, led by aggressive CEOs, strived to gain greater shares of the mortgage market. For example, Countrywide CEO Angelo Mozillo intended to be "number one," even though early on his friends claimed he considered most sub-prime executives to be "crooks" who made their money by overcharging unsuspecting customers. So, why would his firm become a major factor in the sub-prime fiasco?
Enter the "prisoners' dilemma." As the sub-prime market expanded dramatically and Countrywide's market share of lower income customers began to shrink, stock analysts asked why Countrywide was not part of it. So, Countrywide got into it because Mozillo felt he had no choice. Like the prisoner who adopted the strategy that led to inferior outcome for the group because he felt he had no choice, individual lending institutions adopted lower lending strategies.
From the individual viewpoint, better to lower standards and gain market share than be left in the dust, aced out of the mortgage market - like the prisoner who would have been left taking the rap if he denied while his partner in crime confessed. Even as Mozillo publicly maintained that Countrywide was a responsible lender, he was trapped in the logic of rational irrationality of the prisoners' dilemma. It brought the firm to the brink of collapse.
Even if lenders recognized risk, they believed they could pass it along.
Sub-prime risky mortgages could be "securitized" - sold to Wall Street firms, bundled into various financial packages, and sold to investors. This process relieved lenders of risk while providing capital to make more loans. Wall Street firms reaped hefty fees for these products of "bundled mortgages" that were difficult or impossible to analyze. Then came derivatives such as credit default swaps and synthetic default swaps, supposedly "insured" by firms such as AIG. These firms took on the risk normally taken by banks. But unlike banks, they didn't set aside capital to cover losses.
Since credit default swaps were unregulated, there was plenty of scope for creativity. It was an era where deregulation held sway. Rating agencies - Moodys, Fitch, and Standard and Poors assigned AAA to these financial products. Recall that rating agencies are paid by the firms whose products they rate. If a rating agency balks at assigning AAA, another firm will be happy for the business - another instance of the prisoners' dilemma.
Proponents of free markets saw all this as "healthy innovation," risks chopped up and apportioned to institutions that wanted to assume them. Not everyone agreed. Warren Buffet warned that large amounts of risk have been concentrated in the hands of a relatively few derivative traders, calling derivatives "financial weapons of mass destruction," carrying dangers that are potentially lethal.
Buffet was right, and Alan Greenspan was wrong in asserting that the collective wisdom of the market and market discipline would make regulation and government intervention unnecessary. Inevitably, the market for these risky mortgages froze up, bursting the housing bubble.
When the housing bubble burst, potential failure of the nation's large highly leveraged financial institutions threatened to bring down the entire national economy. Both the Bush and Obama Administrations were compelled to take emergency action. But it was Middle America that took the real hit. Middle-class Americans have much of their wealth and savings in home equity. According to Harvard's Martin Feldstein, Americans have lost over a trillion dollars in home equity this last year alone. This loss in wealth is a major factor, though not the only one, causing this Great Recession to stubbornly hang on.
Wall Street is criticized for greed. But let's face it - you can't take greed out of Wall Street any more than you can take politics out of Washington or keep fish from getting wet. What can be done, however, is to channel greed, or incentives if you like, to activities that benefit society - to channel financial resources into productive enterprise rather than into a financial house of cards. But this requires rules, laws, and regulations that are enforced. We can't depend on "Scouts' honor."
The lack of spending power by the American middle class causes this Great Recession to linger. An unregulated, or deregulated financial system complicit in the housing bubble, fueled by perverse incentives of the prisoners' dilemma, brought on the housing slump that robbed the middle class of wealth and spending power. Yet the same politicians who complain of the "bail out" of the financial institutions advocate further deregulation the financial system. The lesson is that we should take every measure to make sure that it doesn't happen again.
Free market advocates set great store by incentives. Ironically, sensible regulations, and a culture that insists on regulatory agencies doing their job, can protect financial institutions from the incentive to adopt the "rational irrational" strategy of the prisoners' dilemma - the dominant strategies and incentives that got us into this fix in the first place.
- John Waelti of Monroe can be reached at jjwaelti1@tds.net. His column appears each Friday in The Monroe Times.
Many factors led to "the perfect storm," causing the Great Recession. The sub-prime mortgage fiasco was the pin that pricked the housing bubble, setting off the recession. The perverse incentives of the Prisoners' Dilemma (Times column of Oct. 21) illustrate the process leading up to this fiasco.
For decades, the business of buying and selling homes was relatively simple, involving realtors, buyers, and lending institutions that examined a buyer's ability to pay and required a substantial down payment. During the 1990s, new types of mortgages such as adjustable rate mortgages and interest only mortgages, along with new entrants into the mortgage-writing industry, led to deterioration of lending standards.
Steadily rising housing prices, lax credit standards enabling newly eligible buyers, and more competitors in the mortgage writing business combined to drive up housing prices, a trend which fed upon itself. As long as housing prices were believed to escalate skyward, even the interest-only mortgage seemed no problem to either buyer or lender.
Firms such as Countrywide Financial, led by aggressive CEOs, strived to gain greater shares of the mortgage market. For example, Countrywide CEO Angelo Mozillo intended to be "number one," even though early on his friends claimed he considered most sub-prime executives to be "crooks" who made their money by overcharging unsuspecting customers. So, why would his firm become a major factor in the sub-prime fiasco?
Enter the "prisoners' dilemma." As the sub-prime market expanded dramatically and Countrywide's market share of lower income customers began to shrink, stock analysts asked why Countrywide was not part of it. So, Countrywide got into it because Mozillo felt he had no choice. Like the prisoner who adopted the strategy that led to inferior outcome for the group because he felt he had no choice, individual lending institutions adopted lower lending strategies.
From the individual viewpoint, better to lower standards and gain market share than be left in the dust, aced out of the mortgage market - like the prisoner who would have been left taking the rap if he denied while his partner in crime confessed. Even as Mozillo publicly maintained that Countrywide was a responsible lender, he was trapped in the logic of rational irrationality of the prisoners' dilemma. It brought the firm to the brink of collapse.
Even if lenders recognized risk, they believed they could pass it along.
Sub-prime risky mortgages could be "securitized" - sold to Wall Street firms, bundled into various financial packages, and sold to investors. This process relieved lenders of risk while providing capital to make more loans. Wall Street firms reaped hefty fees for these products of "bundled mortgages" that were difficult or impossible to analyze. Then came derivatives such as credit default swaps and synthetic default swaps, supposedly "insured" by firms such as AIG. These firms took on the risk normally taken by banks. But unlike banks, they didn't set aside capital to cover losses.
Since credit default swaps were unregulated, there was plenty of scope for creativity. It was an era where deregulation held sway. Rating agencies - Moodys, Fitch, and Standard and Poors assigned AAA to these financial products. Recall that rating agencies are paid by the firms whose products they rate. If a rating agency balks at assigning AAA, another firm will be happy for the business - another instance of the prisoners' dilemma.
Proponents of free markets saw all this as "healthy innovation," risks chopped up and apportioned to institutions that wanted to assume them. Not everyone agreed. Warren Buffet warned that large amounts of risk have been concentrated in the hands of a relatively few derivative traders, calling derivatives "financial weapons of mass destruction," carrying dangers that are potentially lethal.
Buffet was right, and Alan Greenspan was wrong in asserting that the collective wisdom of the market and market discipline would make regulation and government intervention unnecessary. Inevitably, the market for these risky mortgages froze up, bursting the housing bubble.
When the housing bubble burst, potential failure of the nation's large highly leveraged financial institutions threatened to bring down the entire national economy. Both the Bush and Obama Administrations were compelled to take emergency action. But it was Middle America that took the real hit. Middle-class Americans have much of their wealth and savings in home equity. According to Harvard's Martin Feldstein, Americans have lost over a trillion dollars in home equity this last year alone. This loss in wealth is a major factor, though not the only one, causing this Great Recession to stubbornly hang on.
Wall Street is criticized for greed. But let's face it - you can't take greed out of Wall Street any more than you can take politics out of Washington or keep fish from getting wet. What can be done, however, is to channel greed, or incentives if you like, to activities that benefit society - to channel financial resources into productive enterprise rather than into a financial house of cards. But this requires rules, laws, and regulations that are enforced. We can't depend on "Scouts' honor."
The lack of spending power by the American middle class causes this Great Recession to linger. An unregulated, or deregulated financial system complicit in the housing bubble, fueled by perverse incentives of the prisoners' dilemma, brought on the housing slump that robbed the middle class of wealth and spending power. Yet the same politicians who complain of the "bail out" of the financial institutions advocate further deregulation the financial system. The lesson is that we should take every measure to make sure that it doesn't happen again.
Free market advocates set great store by incentives. Ironically, sensible regulations, and a culture that insists on regulatory agencies doing their job, can protect financial institutions from the incentive to adopt the "rational irrational" strategy of the prisoners' dilemma - the dominant strategies and incentives that got us into this fix in the first place.
- John Waelti of Monroe can be reached at jjwaelti1@tds.net. His column appears each Friday in The Monroe Times.
