Wednesday, July 30, 2008

The Mortgage Market and Incentives

This post is a follow-up to my post of July 27, 2008, “It’s All a Matter of Incentives.” The major concern I was trying to express in that post was that “Incentives are the cornerstone of modern life” (Freakonomics, p. 13) and that Congress and the Administration need to be careful with the incentives they set up because people will not only respond directly to the incentives they set up, but will also attempt to circumvent these incentives if there is economic justification to do so. It is a reality of the situation that this latter behavior may produce results that are contrary to what Congress and the Administration hopes to achieve.

I stated that “The subprime mortgage market is the premier current example” of this type of situation where good intentions have gone awry. These good intentions are captured in the first type of incentive that contributed to the creation of this market: “There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home.”

For a long time, owning one’s own home has been the ultimate hope of the American middle class. This dream has been pictured in stories, novels, radio shows, movies, and TV. Supporting this dream has been a foundation stone to the community of politicians. Throughout most of the 20th century politicians have created programs that encouraged and fostered home ownership from the creation of Savings and Loan Associations, dedicated to home finance for the middle classes, to the Federal Housing Authority and other programs developed in the 1930s, to the programs to help GIs after World War II attain their own homes. Helping Americans obtain their own home has been the bedrock of politics for a long, long time.

The effort to create a derivative security that would allow more funds to get into the housing market came about in the late 1960s and early 1970s. This move to create a derivative security with mortgages as the underlying asset was politically driven. The issue was this: insurance companies and pension funds have lots of money to invest in longer term assets. Mortgages are a longer term asset. But, mortgages are held on the balance sheets of depository institutions and when these institutions are fully lent up there are no more funds to support housing ownership and housing construction. How, the question was asked, can mortgages become acceptable assets for insurance companies and pension funds to invest in? At this point investment bankers were brought into the process to help the politicians in Washington, D. C. create an instrument that depository institutions could use to sell the mortgages they previously had held and sell these instruments to those that had so much money available for investment in longer term assets. This would thereby free up funds for the depository institutions so that they could go out and lend more to the housing market spurring on home ownership and home construction. This would result in an economic and social environment in which elected politicians could get re-elected.

We don’t need to go into the details of the construction of the mortgage-backed security because that is not the thrust of this post. All that needs to be said is that over the next fifteen years, the market for mortgage-backed securities became the largest part of world capital markets and the dull-as-can-be mortgage became one of the stars of the speculative universe. This latter point is most memorably captured in the book by Michael Lewis, “Liar’s Poker”.

The point: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people clever and otherwise, who will inevitably spend even more time trying to beat it…” (Freakonomics, p. 25) The politicians saw to it that the incentive scheme was created…and then human nature took over. And, as they say…the rest is history.

The creation of the subprime market (and others) is just an add-on to this story. The political desirability of such a market is that funds for home ownership could be pushed down below the middle class into segments of society that had not, previously, had access to mortgage funding. With this innovation more and more Americans could live the dream and politicians could walk away knowing that they had contributed to building a better America…and, the best thing was that it cost the taxpayer nothing…or, at least, as originally conceived it cost the taxpayer nothing. Now the incentives spread from mortgage brokers, to depository institutions, to other financial institutions and to the rest of the world. This scheme really worked…and more and more people wanted to get their piece of what they saw as an expanding pie. This ‘new world’ of finance was different from what existed before. This ‘new world’ would continue to grow and grow.

The problem is that the subprime mortgage worked only in periods when there was inflation in housing prices. The scenario is described in an article in the New York Times about IndyMac, the failed mortgage lender. “Executives at IndyMac, like many other people on both Wall Street and Main Street, apparently never dreamed that home prices might fall. To the contrary, IndyMac made many loans on terms that implicitly assumed prices would keep rising.” The bank lent to people that were below standard in terms of credit quality and did not require “documentation to verify their income and assets.”

“As long as home prices continued to go up, the company’s strategy was very lucrative for executive, employees and shareholders…the boom perpetuated an insatiable hunger for mortgages and…the sales culture took over, and the sales division really drove the company. (See, But, if the market provided positive returns at the beginning, the positive returns drew more and more people into the practice and the added competition drove away the returns and resulted in the participants taking on more and more risk in an effort to make their efforts work.

This was the intended focus of my earlier post, to show how incentives can create further incentives and lead people to chase positive returns by seeking an edge over their competitors. In addition, it is important to document how politicians, chasing a particular outcome, can create incentives that end up resulting in behavior just the opposite of what they desire to achieve.

And, the beat goes on. Splattered all over the July 29 newspapers, we see the news that politicians are still attempting to shore up the housing and mortgage markets. (New York Times:; Wall Street Journal:; Financial Times: Hank Paulson, US Treasury Secretary issued guidelines on the development of a covered bond market. Covered bonds are a form of secured bank debt that gives investors recourse to an issuing bank’s balance sheet and a pool of collateral, usually high-quality mortgages or public-sector loans, if the bank is unable to repay its debt. The reason for this…”to increase the availability of affordable mortgages.”

The role or roles of the Federal Reserve? First and foremost, the Federal Reserve is responsible for the amount of inflation in an economy. Inflation is everywhere and at every time a monetary phenomenon. I believe this. Where is the measure of inflation or potential inflation captured? I believe that Paul Volcker is right when he says that the most important price in an economy is the price of a country’s currency in foreign exchange markets and this captures market expectations of inflation, both current and in the future. The Federal Reserve must not have a bifurcated policy directive…price stability and economic growth. It cannot serve two masters. We see this particularly in the behavior of the Fed over the past seven years as it relinquished its independence and under wrote the inflation in the housing sector so as to support the administration’s economic policy. A central bank cannot do this.

There are two secondary roles that the Federal Reserve plays. The first of these is to help the financial markets avoid a liquidity crisis. This function the Fed performed admirably in March and April of this year. But, once the crises period has been passed, the Fed needs to back off. The second role is to see that the banking sector remains solvent. This responsibility has to do with the capital requirements in effect in the banking system. All other roles that can be assigned to the Federal Reserve must be carefully weighed and considered before they are implemented. I hope this clarifies where I position myself on some of these issues.

1 comment:

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